Avoid the 5-Year Fixed Mortgage Trap

Should I go short or long; fixed or variable with my mortgage?

“I wish I had an answer to that, because I’m tired of answering that question.” – Yogi Berra

Number 3 on our list of things on which Canadians waste the most money is 5-year fixed mortgages.

They are marketed as being safe and a good protection against a sharp rise in interest rates. The reality, though, is that they are nearly always a huge waste money, they limit your flexibility and result in losing your negotiating power for 5 long years.

That is why we call it the “5-Year Fixed Mortgage Trap”.

I am not a mortgage broker, but have researched mortgages and always have strong opinions. The most common questions about mortgages are “short vs. long” and “variable vs. fixed”. Which is better? Canadians often debate this, but studies consistently show that short beats long and variable beats long term fixed.

If it is so obvious, then why doesn’t everyone see it? Longer term mortgages are marketed heavily by banks and mortgage brokers that make far more money on them then short term mortgages. Also, most people are bad at math and may get a general feeling of security from a fixed rate, but they do not do the math on how much this protection costs or the odds that they will lose money.

“Unfortunately, most of the existing folklore and advice is rarely subjected to formal statistical analysis and does not address the probability that a given strategy will be successful.” (Moshe Milevsky) The main reasons commonly used for taking 5-year fixed mortgages turn out to essentially be myths:

3 Mortgage myths about 5-year fixed mortgages:

1. They are safer

A study by Moshe Milevsky, finance professor at York University, from 1950-2000 showed that the average Canadian wastes $22,000 after tax (based on a $100,000 mortgage for 15 years) in their life because they got sucked into 5-year fixed mortgages rather than variable.

If your mortgage started at $300,000, then you can expect to waste $66,000. They also took on average 38 months longer to pay off their mortgage. The chance of losing money over 5 years was 89%. A study by Peter Draper (mortgage broker) comparing 5-year vs. 1-year mortgages from 1975-2005 showed that the 1-year mortgage saved money 100% of the time! How can an 89-100% chance of losing thousands of dollars be safer?

2. Rates may go very high like in the 1980s

I was an accountant for a mortgage company in 1982 when mortgage rates peaked at 22.75%. My first mortgage was a 5-year fixed in 1980 at 13.75%. I thought that I had lucked out, since rates jumped to 22.75% and were back to 13.75% by 1985 when it came due. What I didn’t realize was that, even then, I would have saved money by going variable! Based on Peter Draper’s study, I would have lost money for 2 years and saved money for 3 years. So, even with a huge leap of 9% in mortgage rates in the first 2 years of my mortgage, I still lost money with a 5-year fixed rate!

Also, the odds of a huge rate rise are extremely low. We can’t calculate them, since it has only ever happened in the early 1980s, but the odds must be extremely low. Demographers, like Harry Dent, claim it related to Baby Boomers entering the housing market for the first time, which is a phenomenon we don’t expect to be repeated in the next few decades.

3. Your mortgage payments will stay the same

Most variable mortgages also keep your mortgage payment the same during the term. Many people believe that their mortgage payment will fluctuate with a variable mortgage, but this is also a myth.

Top 4 reasons to stick to short or variable mortgages:

1. Save thousands

On average, you should save 22% of the starting amount of your mortgage and pay it off 38 months earlier. (Moshe Milevsky) In the Toronto area, an average mortgage is $2-300,000, which would be savings of $44-66,000 after tax. That is essentially one full year’s earnings, so the average person works one extra full year just to pay the money wasted by taking 5-year fixed mortgages!

2. Low risk

With variable mortgages, the chance of saving money is 89-100%. Yes, the variable is the low risk!

3. Flexibility

Many things can happen in your life in 5 years that may make it advantageous to refinance. You may want to move, roll in other debt to get the lower rate, make extra payments with no limit or change some terms. Our experience with our clients is that most do some sort of refinancing every couple of years, so being locked in for 5 years is a long time.

4. Negotiating power

The mortgage market is very competitive, so every time your mortgage comes due, you have lots of negotiating power. You can change any term you want, get a free appraisal, negotiate a lower rate, or get an unsecured credit line or other banking service. During the term, you have hardly any power. Remember that when you sign a 5-year mortgage, you sign away your negotiating power for 5 years!

The main reason that 5-year fixed mortgages lose money vs. 1-year is that, in a normal market, they start about 2.5% higher. If you pay 2.5% more in year 1, you need the average for years 2-5 to be more than 3% higher than today’s rate. To be ahead, rates would have to jump by more than 3% and stay there for the next 4 years – a very unlikely scenario.

Conclusions:

Stick to 1-year fixed or variable mortgages. Usually, you should take whichever is lower, but only take variable at a good discount, such as prime -.8-.9%.

Avoid 5-year fixed. Sometimes, they are tempting, but always assume they will end up costing much more, plus you will have lost your flexibility and negotiating power for 5 years. Remember that even when rates leaped 9% in 2 years from 1980-82, short term rates still saved money.

Never take a mortgage term longer than you expect to stay in your current home.

We have been referring people to mortgage providers since the mid-90s and most today have rates below 2%. Most of our clients still have the prime -.85% rate that we had for years before this recent crisis or have our recent 1-year rate of 1.99%.

Today, we are recommending 1-year fixed, not variable. The best variable rates are prime -.4-.6%, but rates are normalizing quickly. We expect that the prime -.85% (or lower) rates will be back soon. We expect that anyone taking a variable today will regret having locked in before the larger discount is available.

Ed Rempel is a Certified Financial Planner (CFP) and Certified Management Accountant (CMA) who built his practice by providing his clients solid, comprehensive financial plans and personal coaching. If you would like to contact Ed, you can leave a comment in this post, or visit his website EdRempel.com. You can read his other articles here.

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About the author: Ed Rempel is a Certified Financial Planner (CFP) and Certified Management Accountant (CMA) who built his practice by providing his clients solid, comprehensive financial plans and personal coaching.

Ed has written numerous articles to educate the public and his clients on his unique insights into strategies that actually work, instead of the “conventional wisdom” common in the financial industry.

Ed has trained more than 200 financial advisors and is considered the Smith Manoeuvre expert in the Toronto area. He has received accolades from Frasier Smith in his book “The Smith Manoeuvre” for customizing this strategy for hundreds of clients. His extensive experience in tax and finance has placed him in high demand. Ed’s team collaborates on each of their clients to help them create financial security and freedom.

You clearly have no concept of risk management. Not everybody has the incredible tolerance for risk that you and apparently your clients have.

I have a 5 year fixed because at the time we renewed the mortgage amount was too high for us and we couldn’t afford any kind upswing in interest. This is unfortunately a pretty common situation although it is avoidable (ie don’t buy too much house).

We have been able to payoff about $150k of the mortgage over the last 3 years and it is now at a very moderate amount. If we were renewing now I would likely favour a variable.

The mortgage pre-payment amount is fairly high (20% of the original mortgage) and we have been moving part of the mortgage to our line of credit (lower interest rate) which has saved a bit of money.

As for Milevsky’s study – can’t you find something that uses newer data? I don’t doubt that his findings were valid from 1950-2000 but come on – the financial industry has changed so much since 2000 that I’m not all that confident his study is all that relevant anymore.

You raise some very valid and interesting points here, but I think Mike’s rebuttal is fair too. Everyone’s situation is unique and sometimes a 5 year fixed is really the best way to go.

Having said that, I am currently regretting our decision to renew for 5 years a couple of years ago when rates were higher. At the time though, the economy looked very poor and we wanted the stability of a fixed rate given that our income is extremely variable.

We ended up being able to pay down quite a bit of the principal since then, but we weren’t sure about that when we renewed. Now we have about 3 years left in our term, but only about 2 years left in amortization. Hindsight is 20/20!

When it comes to a fixed or variable term, variable has proven to be the better course to take, however, risk has to be measured.

I met with a client a few weeks ago that had a lovely (sarcasm) 40 year mortgage at a 1.65%. My first observation, wow, 40 year mortgage at age 50 and retiring in 10 years. Second observation, he couldn’t afford a traditional 25 year mortgage so that lender made him “afford his home” using a 40 year mortgage. Third observation, when not if but when interest rates increase in the next year or two he will be forced to drastically change his lifestyle in order to keep up with his payments. I gave an example of a varaible rate increase of 2% and at that point he would have to sell his home.

Cash flow is essential to deciding which product to choose. Sure, the variable rate mortgage has always proven to be the better way to go, but if your cash flow does not allow you to accomodate for any interest rate increases than there’s a problem.

Get ready Canada, those people sitting with a 30 plus year mortgage and enjoying the joys of a low interest rate will have to adjust their lifestyle (cash flow) in order to keep up with the payments. The kicker is that they can’t even flip into a fixed mortgage because the rates there definitely make their home unaffordable.

Thank you Ed. This was a very thoughtful and well presented post, and extremely informative.

I do think that there was a historic blip that occurred recently with the credit crunch, where variable rates climbed but the fixed rates were very low still.

At the time, I bought my house about 9 months ago, the variable rates were prime + 0.5% (or 2.75% and that’s after alot of shopping around), while we got a five-year fixed for 3.4%. So the spread was 0.65%. Considering where the rates are going, this was a no brainer to go for the fixed.

In general, your analysis is correct, and I think going variable is the route to go and I will certainly relook at the 1 year-fixed term contracts, but I think we just went through an abnormality in credit lending which means the studies quoted earlier aren’t entirely relevant. We’ll see how it plays out, as I’m sure I’m saving money over the longer term with a five-year fixed in this very unique circumstance.

I liked this article. We’ve been enjoying a prime minus 80 mortgage for almost 5 years, and we’ve saved a lot. (I really should crunch the numbers and figure out exactly how much we have saved!) With regards to your myth number 3, our payments have fluctuated with rate changes, so I don’t think it would be safe for someone taking on a variable rate mortgage to assume their payments won’t change when rates change. Our mortgage is up for renewal in 2 months, and the low fixed rates of a few weeks ago are being held for us – I’d still rather go variable again, but I’m hoping the spread will increase in the next couple of months! It’s a bit of a tough decision when fixed rates are so low right now.

I’m not sure myth 3 is entirely true. When I was shopping around for mortgages, the Big Banks had variable mortgages with fixed payments, but everyone else was offering variable mortgages with variable payments.

When I went to get a mortgage on my new home nine months ago, all of the banks were “offering” prime + 0.75, I was uanble to negotitate a “prime minus” mortgage. Interest rates were low and have risen a lot more than the prime rate. I decided to go with a long fixed rate mortgage despite being good at math and aware of the studies, and got a low enough rate that I fixed in for the entire life of the mortgage. Was this foolish? Time will tell, but this article did not convince me. During Milevsky’s study, how often did interest rates as low as they possibly could, so that they would have to rise? During how many of those years was it impossible to get a “prime minus” mortgage even with a good FICO score? I saved money by paying off the prinicipal, getting a good rate, getting a shortish mortgage with an accelerated weekly payoff. These factords make a bigger difference than, at best, saving 1% or so on the decent rate I eventually got. This article liberally applies a $22,000 savings to every year and is cavalier in assuming savings of 89-100% — but maybe things are differnt when rates are at a historical low and de facto minimum. I don’t want to renegotiate my mortgage every two years, and a prime – 0.85 rate was impossible to get at the time I got my mortgage.

variable is a the way to go if you can handle fluctuations, I know several people who bought housing in the last 2 years and are barely making it on a couple of % mortgage, what will happen to these people when prime hits 5-6% and yes, it will get there, sooner then most think.

I am a CFP and Mortgage Broker so I know a bit about this as well. I give my clients all the options including variable rate mortgages that “cap” at the 5 year fixed rate posted at the time they took out the mortgage and 50/50 mortgages where half the amount is at the 5 year fixed rate and half at the variable rate. You are correct that some mortgage brokers go for the 5 year fixed for higher commissions but the Financial Planner in me is always trying to save my clients money and give them prudent and unbiased advice. Like Mike, I suggest a strategy that uses the straight interest of a HELOC to lower the effects of amortization and reduce the time needed to pay off the mortgage and save a ton of money in payments.

I think most variable rate mortgages have fluctuating payments. I know that ING Direct changes the monthly payment every 3 months if there were any changes in prime. For those who are afraid of higher payments that they can’t afford in future years, they could consider this strategy: calculate the fixed monthly payments you would make if you had chosen a 5-year fixed. Then every time you make a mortgage payment, calculate the difference between that payment and the hypothetical payment. Invest that difference in a short term GIC or high interest savings account, so that you’re effectively paying the 5-year payment amount but putting some of it aside. In the future, if prime really does get to 6% in less than 5 years, then withdraw the difference from the savings account. Having the lower mortgage rate initially means you’ll pay down more of the principal, AND have built up a decent savings account that’s earning interest. It’s still possible that the savings could run out, but as Ed points out, the variable rate statistically has a much better chance of ending up costing you less! The biggest problem with this strategy is that people can’t seem to leave those savings alone (I really needed a new car and that money was just sitting there…)

All fine and well… but there is certainly an aspect of risk management that is very important in this and it is hard to quantify. My family was wiped out in the early 80’s because of high interest rates and a variable rate mortgage. The payments balooned so much that we were unable to service them and ended up walking away from our home and having to start all over again after the dust settled. Price of locking in and avoiding that destructive trap? Worth every penny.
Easy to say that rates won’t go back to 20% when we’re at historically low rates… but no one can predict the future and I’d rather not roll the dice on something this important. Even a 5% chance of financial ruin is more risk than I’d like to entertain when I can pay to avoid that collapse. Trying to sell a house when rates are that high will result in wiping out any equity you may have built up, since house prices and rates are negatively correlated.
Many economists are predicting rates increasing by 3% over the next two years. Locking in now would result in interest savings over the next 5 years if this turns out to be the case. And I believe that 3% is just the beginning. We’re entered a new era of increasing interest rates as governments scramble to cover their balooning debts. Caveat emptor!

I think a significant problem is that people buy too much house. I would gladly choose a more modest house and a variable rate. If you are at the top of your affordability that’s a problem. What do you do when you have to renew your mortgage in 5 years and the rates are higher?

I have seen two people living in a 6000 square foot home with the heat almost off to reduce expenses. My family lives quite comfortably in 800 square feet and we also heat it :)

It’s not a dream house but it is warm and dry. There are no Scarlett O’Hara staircases and ensuite bathrooms or walk in closets but it took five years to pay off.

Mike said:
“the financial industry has changed so much since 2000 that I’m not all that confident his study is all that relevant anymore.”

I was wondering if his point would apply to other areas of finance: EMH, fundamental/technical analysis or the statistics they use in the insurance business. What about CAPM, modern portfolio theory and diversification?

If the financial industry is ever-changing, could it be that these theories have become obsolete?

Especially now we are being bombarded with big bank ads and “analysis” pieces in the financial section of every published rag, that the sky is falling and the interest rates are going to skyrocket.

What most people fail to understand is that by selling you a five-year fixed rate a bank, has made 100% sure that they will not lose money on this mortgage, in case the prime rate were to rise as they are predicting.

The fact that they push this product down people’s throats via scare tactics, and always downplay the variable rate, shows that the variable rate is good for the consumer, and the bank makes less money there.

So what does “fixed payment variable” mean other than it being an oxymoron? Doesn’t it just reduce principal repayment to compensate for higher rates, or can someone clarify if there is some sort of magic going on?

I can’t figure out how a variable rate at 2% changing to 5% won’t result in higher payments, even at 0 principal repayment.

@jesse
Some variable rate mortgages are set up so that your payment will remain the same, regardless of interest rate movements. If rates drop, more of your payment will go towards principle, and your amortization will be reduced. If rates rise, less of your payment will go towards principle, and your amortization will be increased. With these types of mortgages, your payment amount will only be changed if rates rise to the point where the payment no longer covers the interest being accrued.

Myth # 3 is misleadingly incomplete. Yes you can get fixed payment variable rate mortgages, but you trade a fixed payment for a fluctuating amortization period. i.e. If the interest goes up, less of your payment is applied to principal and it can end up taking you longer to pay of your mortgage than you planned. This in itself is a risk.

@YYC81: thanks for the clarification. So I just increase loan amortization period when rates go up to reduce monthly payments. In other words I save less. Hardly a benefit at all in my books as I pay interest for a longer period.

Variable rates are best used as long as your time horizon matches the investment. If we’re talking about a 40 year investment there needs to be some provision for pro-cyclical debt ratios: the very time you should be paying down debt is exactly the time when you can’t afford to do so due to high interest rates. This is part of the reason why there is a “discount” for shorter term rates and why, contrary to the thesis in this post, rational Canadians pay a premium for stability.

I’m one of those that let myself get trapped–2.5 yrs ago was offered “staff” rate and went for it. A wonderful follow-up article would be “What to do next for those in the trap”. I’ve used Prof. Milevsky’s calculator to see if it is worth it to break the mortgage, but it doesn’t seem so in my case. Should I at least be transferring that annual lump sum amount to my HELOC even if it will sit there for a while?

I know this doesn’t apply to most of the scenerios discussed here of people barely making their payments on their low interest variable rate mortgages, but I know in our situation at least it has allowed us to make significant extra payments to our mortage.

Every two weeks with the mortgage payment we take the difference between what our payment is and what it would be using our banks current fixed rate and put it away. When the pot hits a certain value ($500 at the moment) we make an extra payment. This way we’ve gotten used to paying more in case rates do go up. As well, these extra payments are straight premium and not premium plus interest like they would be if we actually were paying that higher interest rate.

But yes, it does come back to the idea of not buying too much house. Obviously this wouldn’t work if we HAD to take the low percent variable mortgage in order to make payments.

Elbyron: you’re better off just setting your payment to the same as the 5 year fixed amortization than saving the spread in a GIC. Mortgage prepayments are like tax-free savings, whereas GIC interest is taxable. If rates rise such that your variable payment is higher than the 5 year fixed payments were (despite your early principle pre-payments), and you can’t adjust your spending accordingly, just get a HELOC.

When I entered the business I was surprised to find out that variable rate mortgages that cap at the 5 year rate exist, same with 50/50 mortgages. Nobody here seems to have an opinion on these as options for those who would like a lower variable rate but don’t want to be caught with their pants down if we see significant rate hikes over the next few years.

Let me address the issue of risk. If you take a 5-year fixed or a 5-year variable, in both cases you can make exactly the same payments for the entire 5 years. If interest rates rise, in both cases, you are still making the same mortgage payment. Your mortgage comes due at the same time.

It is correctly pointed out by some here that some variable mortgages change payments periodically, but our contacts are mainly with the major banks and their mortgage payments stay the same for the entire term of the mortgage. If rates rise, you just pay less principal.

The only major difference is that with the variable you have a 93% chance of having a lower mortgage balance at the end of the 5 years.

In a normal interest rate environment, the variable rate is roughly 2.5% lower than the 5-year fixed. So, then the fixed cannot possibly save money without a rise in rates of at least 3% and rates staying high for years.

I would suggest that the 5-year fixed is not the low risk option. The low risk option is the 5-year variable (with a fixed payment).

Moshe Milevsky’s study still applies. We have been recommending either variable mortgages or 1-year fixed for about 15 years and I’m sure we saved money over the 5-year fixed for all of the last 15 years.

You’re right that the spread between variable and 5-year fixed was very low a year ago. That is why we always look to see whether variable or 1-year is better.

Last year, we were getting 1.99% on a 1-year fixed. That was .76% below the variable and 1.41% below the 5-year fixed. Those mortgages are starting to come due now and rates are still low, so those clients will have at least 2 years at rates much lower than the very low 5-year fixed you took that looked so good.

Now, we are getting 2.15% on a 1-year fixed. This is only slightly up from last year’s 1.99%.

My point is that the 5-year fixed often LOOKS good, but if you take the best deal between 1-year fixed and variable, you can virtually always save thousands.

We would suggest to essentially never even consider the 5-year fixed. Only look at variable and short term fixed.

Your point sounds logical but is not supported by the study. In fact, very shockingly, the variable rates have always saved money during rising rate environments.

During the 1950s and 1960s, rates were low and rose steadily. During that time, there was a wider difference between the variable/short term rates and the 5-year fixed.

In general, the difference between the short term/variable rates and the long term fixed is wider during periods when rates are expected to rise.

Interestingly, during these periods of low rates from 1950-68, if you ever took a 5-year fixed, prime stayed below that rate for all of the next 5 years. During that time, variable saved money every single month of every single mortgage!

The really interesting point is that the only times that 5-year fixed saved money over variable where 1987-88 and 1992-4 – both of which were periods of FALLING rates. Both periods had falling rates where an unexpected economic shock resulted in a small rate boosts that only lasted a few months.

During periods when rates are falling, there is usually a smaller difference between the short and long term rates, so that has been the only times when a short term, surprise rate bump could result in the 5-year NOT losing thousands of dollars.

I was thinking about your comment about not wanting to renegotiate your mortgage every 2 years. Why not???

We find this to be one of the weirdest points of all. One of the main ways people get sucked into 5-year fixed mortgages is because of the bad service on mortgage renewal. Banks actually make tons of money because people dread renewing their mortgage – so they agree to pay thousands more every year!

We do all the negotiating for our clients and teach them the benefit of negotiating. It is fun and one of the most profitable activities you will do in your life.

Renegotiating usually takes only about an hour, including meeting to sign papers. Our contacts often go to meet their clients, so renegotiating could take as little as 10 minutes.

Meanwhile, most mortgage holders in the Toronto area have mortgages of $2-300,000, so in normal market conditions they waste $2-5,000/year because of their 5-year fixed mortgage.

So, let’s do the math. I spend an hour renegotiating my mortgage and therefore save $2-5,000/year for the next 5 years. So, I made $10,000/hour after tax for my 1 hour of work. That has got to be one of the most profitable hours of my life!

Why would you NOT want to renegotiate?

It is also fun!

We constantly negotiate between our various mortgage contacts. We try to always have the best possible rate for the term we are recommending at the time. So, our clients can just take our referral. (We still offer “Ed’s Mortgage Referral Service offered on this site for MDJ readers, as well.)

But for those that want to negotiate on their own, we just tell them the rate we are getting and they ask their bank if they will match the rate, and the terms.

There is no need for bluffing or playing games. Just see if your bank will match the best available mortgage. If you will actually move the mortgage if they don’t match, then it is amazing how often they will match. It is quite fun to do this process (when you know what is reasonable to ask for)!

Great suggestion to write an article about “What to do next for those in the trap”.

The calculation of whether or not it is worth it to pay the penalty to renegotiate your mortgage now can be complex. You lose the cost of the penalty, but you save interest rates (and need to make a reasonable assumption about this). You may also be able to save money be refinancing other more expensive debt or using some to invest (perhaps as a low cost RRSP loan).

We are experts in the Smith Manoeuvre and have found it beneficial for many clients (because it helps them save for retirement without using their cash flow), so if that is an option, then the calculation should take into account a reasonable estimate of the Smith Manoeuvre benefit of being able to start now instead of waiting till your due date.

So, taking all these factors into account, it can be complex to figure out whether or not paying the penalty to get out of your MORTGAGE TRAP is worth it or not.

Very very clear and easy to understand artile Ed.
When I first thought of getting a mortgage I did what the majority of people do, automatically thought that fixed would save me money. I am all about planning every penny out, and saving everything I can (while gaining the most profit possible).
So being prepared to pay a ‘slightly’ higher fixed rate, to guarantee that if interest rates were to rise I would be ‘safely secure’, made sense to me… at first. But when a friend (that is a mortgage broker) recommended that I get variable, and a 5-year variable at that, I was skeptical.

The way you state the simple facts here, make it obvious that getting into a 5-year fixed is just as bad as buying a first-to-die policy. Always do the calculations, and if you don’t know how you should learn; before signing anything.

Sure everyone makes mistakes, and ‘most’ people learn from their mistakes, but many mistakes in life can be avoided. And learning from other people’s mistakes can help you out in an extraordinary way!

I find it kind of funny that your article simply points out that variable rate mortgages are statistically proven to save you money. The banks are selling the illusion of safety at a considerable profit margin. Unlike all of us they have risk management specialists helping them set the rates for 5 years so that they are guaranteed to make money.

Ironically we now all have to qualify for the 5 year fixed rate mortgage when buying a property.

The truth is that most people will almost always make emotional buying decisions then use their feelings to argue the statistics.

I read an article a while back about child safety seats which we now have to buy by law until our kids are practically in high school. Basically the study showed that there was absolutely no benefit to any child safety seat past the age of 2. In fact if bad fitting or poorly made seats were taken into account injuries went up. So statistically there were more injuries past the age of 2 since these additional child seats were introduced. It was a very large study over a considerable period of time. Still the responses were quite irrational. People wanted to hold the belief that there was some benefit in spite of evidence to the contrary. Numbers don’t lie.

Second, using more realistic assumptions about fixed vs variable rates (i.e., using discounted instead of posted fixed rates), there were an awful lot of periods (at least 6 over the last 40 years) where the 5-year fixed would have been better. Given that prime has no potential to drop and, until recently you could get fixed for under 4%, there is a very high likelihood that we are in (or just left) one of the periods where fixed would be better.

I actually think that for the most part Ed is right. However, I think the people who locked in a 5 year fixed rate at 3.69% are going to end up ahead of the variable rate guys over the next 5 years. Read my more detailed analysis of it:

Part of why I am passionate about this is that most people don’t have a lot to spare and yet waste so many thousands of dollars on 5-year fixed.

The other part is just from experience of all the clients that have had to pay the penalty to get out of a 5-year fixed. We have probably had 100 clients in the last 10 years pay the penalty. They are struggling with high payments or need to refinance for one of many possibly reasons.

So many people have been trapped!

We feel for all the people we’ve met that thought they were doing something safe, but then something changed in their life – and now they are locked in.

Over the last 15 years talking with clients about their mortgages, we continually have run into people paying very high rates, or people that need/want to refinance and are trapped.

The most common situations are:

1. They can save money by paying the penalty and refinancing now. We do the calculations in detail for clients or potential clients about whether or not it is worth it to pay the penalty and refinance, and it is surprising how often clients can save money paying the penalty. From our experience, most 5-year mortgages are worth paying the penalty to get out of at least part of their term.
2. They have accumulated debt at high rates that they are struggling to pay off and need to refinance.
3. They have a mortgage term longer than they expect to be in their current home, so they will have limited negotiating power with the new home. “Blend-and-extend” is a disaster for clients.
4. They want to use their home equity for investment, such as the Smith Manoeuvre, but have the wrong type of mortgage.
5. Their income has plunged and they want to cut their payment to the absolute minimum.
6. Their income has jumped or they received a large bonus and want to pay much more than the minimums allowed.

The extreme has been 2 clients we have met in the last year that are on the verge of bankruptcy because their were “raped” (the client’s words) into taking a 7-year mortgage at 6.99%! The penalty is $35,000 and definitely worthwhile to pay, but the client cannot come up with the $35,000. One had a big pay cut and now must struggle on the edge of bankruptcy for 4 more years! They are truly trapped!

This is why even the thought of a 5-year fixed scares me! How can anyone know that their life won’t change significantly in the next 5 years? If they have a huge change in pay, run up other debt, want to move, or want to use their home equity for other purposes (such as saving for retirement), they will be unhappy being trapped for 5 long years.

My mental picture of a 5-year fixed mortgage is a jail cell – you are trapped with limited flexibility for years and you surrender your negotiating power for that whole period.

Because of the major advantages of flexibility and because we enjoy negotiating, plus all the extra goodies you can negotiate whenever your mortgage comes due, we really prefer short term or open mortgages.

A few comments on this blog seem to assume that the 5-year mortgage is the default, so if their forecast is close, then just go with the 5-year.

Our view is the opposite. If it is close, why would anyone lock themselves in and just give up their flexibility and negotiating power for nothing? We would not consider locking in unless we had a strong opinion of significant savings by locking in. If it looks close, the 5-year fixed would be the last choice.

Our default would be either a 1-year fixed or a variable (preferably variable open). Those would be the terms we would look at, unless there are very strong reasons to consider anything else.

Regarding Moshe Milevsky’s recent article, he says he may be leaning toward fixed, but that was last year when variable were nearly at prime +1%. I wouldn’t lock in a variable at that rate either.

That is why it is usually worth considering BOTH the 1-year fixed and the variable.

We were getting 1.99% for much of last year and are now up to 2.15%. That is almost definitely much better than variable today. With the variable, you can get prime -.5%, or 1.75%, but it will float up in the next year.

More significantly, though, if you lock in prime -.5% for 5 years, you give up the very likely discounts of prime -.85% that should become available soon as rates normalize again.

I agree. Let’s look at this again in 5 years and see which was better. We can compare your 5-year fixed you mentioned at 3.65% vs. the best of 1-year fixed or variable.

What date did you take your mortgage?

I assume you took your 5-year fixed last year. So, the alternative would be 1-year (not variable) at 1.99%.

So, year one goes to the short/variable team by 1.66%!

Let’s see how it plays out.

While 3.65% may look good, our issue is that we don’t really think of that rate as very low. We have been recommending either 1-year fixed or variable for the last 15 years. In the last decade, we were between 4-5% almost all of the decade. There were 2 previous periods between 3-4% and there was only one brief period about 2 months when we drifted slightly above 5%.

Without an actual calculation, I would say our average over the last decade was between 4.25-4.5%. So, at 3.65%, you are only a bit lower than an average rate – say roughly .5% below the average of the last decade.

Today, we have “historical” low rates, well at least the lowest since the 1950s. So why not take a real low rate and enjoy it for a while before going back to normal rates?

I locked in for 5 years in March 2010. Though I agree the trend of the past decade has been fruitful for the frugal mortgager, it also extremely pertinent to point out that trend of 4-5% from commercial banks over the past decade is well below the trend of that past 75 years of 6-7% on central bank rates.

I have no doubt that I’ll be slightly behind for this coming year (quite obvious considering the 2.25% 1-year fixed TD is now offering), but am fairly confident that I will be close to even the year after, and begin the climb to pulling ahead when the 25th month ends. I don’t know analysts who wouldn’t agree that this is what the odds favour.

Now that the option for 3.65% is long gone, I’d agree though, that attaching yourself to a variable rate or a 1-year fixed is likely the best bet for a primary residence at this time.

Now that we’re all simply science experiments, I’ve marked March 2015 in my Google Calendar with reference to this article. Hope we’re all still active come that time. Actually, I’ve marked March of every year for the next five years so we can review the speculation.

I agree that in most instances VRM are advantageous (I have one myself), but as usual, my issue with your posts is that in “trying to educate”, you generally fail to offer both sides of the equation, which ends up doing a disservice to people who are actually trying to educate themselves.

Here, you say: “Avoid 5-year fixed. Sometimes, they are tempting, but always assume they will end up costing much more”.

That simply is not true. The do NOT always end up costing much more. There were at least 6 occasions over the last 40 years (and I’d argue we just left another), where a 5-year fixed rate would have cost you less than either a VRM or a 1-year fixed. By pretending those situations never exist, you are misleading people.

You also neglect to include other real world considerations like risk tolerance. Some people simply cannot afford to take the chance that rates will rise above the 5-year fixed cutoff. It is an insurance policy — we all get “raped” (to use your client’s term) by life insurance, but we pay it anyway because on the (hopefully) rare occasions we need it, we really, really, need it. A five-year mortgage is similar; you pay a premium for certainty. And certainty is not without value.

You did the same thing in your Myths of the Stock Market post where you presented a hypothetical equities return without qualifying it with information about what actual investors make or stage of life, or portfolio allocation, etc.

Don’t assume that your clients are all fools — give them ALL of the relevant information, and they will make the right decision.

“You also neglect to include other real world considerations like risk tolerance. Some people simply cannot afford to take the chance that rates will rise above the 5-year fixed cutoff.”

So when their 5 year term is up and mortgage rates skyrocket to 10%, 15% or 20% like in the 80’s what are they going to do? What’s the difference if you can’t afford your house at year 3 or year 5?

Problem is, people are very bad at evaluating risks. A 5 year fixed is almost always more risky if only for the fact that people don’t know where they will be in 5 years and the flexibility is so important.

Fact is, the $ amount you are paying to the bank is what counts. People are to obsessed with interest rates and amortization periods. You need a good strategy that works for your situation that lets you pay as little extra $ as possible. That includes pre-payment options, the ability to convert interest payments to tax deductible interest with the smith manoeuvre etc…

You should pay your VRM off as if it were at the fixed 4%-5% rate where the additional % points go directly to pay off principle. The PV of your mortgage will be lower after 2-3 years than it would be at year 5 with a 5 year fixed. And yes, most banks do not adjust your payments if interest rates go up until your VRM term is up.

I agree with Paul (and others with similar comments). The problem is buying “too much house” and not the type of rate or amortization period we choose.

The argument of fixed over variable misses the point of why we analyze financial matters in the first place. If you can’t afford a mortgage if rates go up by 3-5%, then get a smaller home as a measure to reduce risk. What if rate go up even more (8-10%) when you need to renew? What then?

Ed, I would take your advice any day. After I do my own research of course ;)

Can you really think of no situations where cost-certainty is useful? Honestly?

How about if I have just graduated medical school, have a great job, but also have lots of student loans that I plan on paying off at the end of 5 years? Or if I foresee that I might need to buy a car at some point in the next 5 years and so want to make sure that I know exactly how much money I will have available to spend/month? Or if I am planning to have a child in 2 or 3 years and so will be living on a reduced income for 18 months? Or if some of my mortgage payment is coming out of rental income, and, while I could afford to live this way with the 5-year rate, I might not be able to if the rate jumped much higher than that . . .

In any of those situations and dozens of others, I’m fine with rates being higher after 5-years time, but would not be fine with rates “skyrocketing” before the end of the 5 years.

Look, I have no problem with arguments for VRM. As I said, I have one myself, for which I have the payments fixed at a rate currently 5% over Prime. It’s a great strategy, and it is probably one that more people should use.

But, I think it is disingenuous to say that it is the best fit for everyone, and that the cost-certainty of fixed rates has no value. Just as the flexibility of a VRM has value, the cost-certainty of a FRM also has value. One-size doesn’t fit all. And it is also demonstrably true that there have been periods where a fixed 5-year mortgage has been cheaper than a VRM.

Your situation will be an excellent example. Last month when you took your mortgage is a very unique situation. We all expect rates to rise significantly plus the difference between the 1-year and 5-year fixed are relatively narrow (normal is close to 2.5% and it was only 1.66% last month).

I can’t off-hand recall a time when the prospects for the 5-year fixed looked this good. My guess is that you would have to go back into the 1980s to find such a favourable scenario.

This combination could hardly be better for the 5-year fixed – but is that enough???

You took your mortgage last month at 3.65%. We were getting 1.99% for all of March until 2 weeks ago. So, the first year from March/10-March/11 goes 1.66% in favour of short/variable.

Let’s say you are right that one year from now rates have jumped roughly by this 1.66% so that we are even for year 2. That means that short/variable is still ahead 1.66% for the first 2 years.

What would the breakeven be for years 3-5? The 1.66%/3=.55%. If we add this to your 5-year fixed rate of 3.65%, you get a breakeven point of 4.2%.

So, under these assumptions, the deciding factor will be whether the best choice between the cheapest variable or 1-year fixed averages more or less than 4.2% for years 3-5.

That 4.2% is quite close to what we have averaged for the last decade, so it could be close!

I should add that, if we knew today that it would end up about even, we would of course definitely choose the short/variable, because that includes complete flexibility plus maintaining our full negotiating power. We would need a significant premium in order to surrender our flexibility and negotiating power.

I’m with you, though. It should be interesting. It could possibly be one of the very rare times when 5-year fixed actually is close! I will also mark my calendar for March in 2011-15 to follow up on this challenge.

Good advise at the wrong time.You go with a variable rate when you suspect interest rates are on their way down, not when your sure they are headed up. I went with variable rate prime -.6 a little less then 2 years ago and kept my monthly payment set to the same as it would have been had i chosen the 5 year fixed. It was a no brainer as the best 5 year fixed i was offered was 5.15. I intended to lock in as soon as the fed (the agency that sets interest rates in the united states) raised rates. I figured that given the high Canadian dollar there was no way the Bank of Canada would move in front of the fed. I was shocked when the B.O.C. suggested they would start raising rates in June. Not only in front of the fed, in front of everybody. looks like Harper Flaherty and Carney could be the second coming of Mulroney Wilson and Crow. At this point a 1-3 year fixed rate might be a better option than a variable. I am by no means a professional consider my points and discuss them with your broker. if you do not have a broker get one

Why would you time your lock-in by looking at Prime rates? Fixed rates (i.e., the rates you lock into) are not tied to Prime (either in Canada or the US). They are tied to bond yields. Variable rates and Fixed rates move somewhat independently of each other, which is why you can have situations where one is rising and the other is falling at the same time.

The time to lock in is not necessarily when Prime is rising, it is when fixed rates are low . . . and that ship, I believe, has already sailed.

I think Jason did the right thing in taking a 5 year fixed at 3.4… I had to renew my mortgage in January… I was in a variable rate at 1.5% but my variable was going to jump to 2% and I was able to lock into a 5 year fixed at 3.6%… I think it will take less than two years into my mortgage before the variable rate matches my fixed… but after that I’ll be laughing because I’ll be paying 3.6 and the variable will be somewhere in the 5% range… I believe that 90% of the time variable rate mortgages are the best way to go… but I believe this is the time to lock into a 5 year fixed!!!

Stanman, if you were getting a mortgage today you could get a 5 year variable that, as of today’s rates, is 2.9% but is capped at today’s posted 5 year fixed rate of 4.64%. Nobody seems to like this option and I’m not sure why. It’s a compromise between a completely variable and a 5 year fixed, offering some protection against large increases in rates while enjoying a lower rate in the meantime. I don’t understand why not a single poster has commented on this option?

Tom who is offering a capped 5 year variable? this would have to be the best comprimise available if the # are correct. perhaps the reason no one has suggested it is they like myself were unaware of this option

It is very interesting how a journalist can make such a broad statement as to state that Variable Rate Mortgages are better for everyone than Fixed. Ed’s facts are somewhat correct. If a client stays in a variable rate mortgage for the entire life of the mortgage… more than likely they will come out ahead.

As many have already commented on, this really comes down to risk. I have presonally dealt wtih more clients who took out mortgages when prime was low at 25-30 year amortizations and very emphatically stated they could handle the risk of rising rates. My one caution to all clients who go into Variable is they need to understand that the interest rate risk and whether it rises or fall is thier risk. A fixed rate term is the banks risk. Banks don’t come back to clients who locked in to 5 year terms at 3.50 when rates for the same term go to 4.00 and tell the client they have to take the higher rate. With Variable terms don’t expect the bank to call you everytime prime goes up! The same as your local gas station doesn’t call when the price of fuel rises… These same client come in 5 year later after an increasing interest rate envirement and believes their amortization should now be 20-25 years only to find out it is 30,40 and sometimes higher. Guess who’s fault it is then ED… bang on!!! the bank, trust company, mortgage broker… Most people have very short memories when it comes to how much risk they can handle.

Lets be realistic Ed. Their are more “variables” to determining what term to go into than simply what safes the most money over a 25 year period… If this were the case I am sure your investment portfolio consists or nothing but equities…. since over the long term they will make you more money….

Ron, as a Mortgage broker I am able to access many sources of mortgages beyond the Big 5 Banks. In the case of the “capped” variable, it’s National Bank. I think they probably offer it at the branch level as well. The 50/50 mortgage (50% at variable rate, 50% at 5 year fixed) is through Merix and is only available through a mortgage broker. Why anyone would just deal with their bank instead of having a mortgage broker shop around for them to find the best rates on whichever type of mortgage product they desire is beyond me. The bank never offers their best rate from the get-go, they make you bargain and act like they are doing you a favor if they meet some better rate you tell them is available elsewhere.

Note, though, that “capped” Variable mortgages (including the one at National Bank) are usually closed 5-year terms rather than open, which takes away a big chunk of the advantage of variable mortgages (i.e., flexibility)

Thats very interesting Tom…. “bargain”…. National Bank’s current 5 years fxied rate listed on their public website is 6.1 compared to:

CIBC 6.1 / TD 4.7 / RBC 4.7 / Scotia 4.7 / BMO 4.7… all listed on the big 5 banks public website. I would deal with one of the 5 big banks before holding a mortgage some company I have never heard of let alone seen any day. And lets be honest, once a broker gets paid, you will never see him / her again until you want to write another mortgage.

Trevor, posted rates mean nothing. National Bank is the 6th largest bank in Canada. I don’t know about other mortgage brokers but I am available to my clients any time. I am also a Financial Planner (CFP) and Tax Preparer. I have many clients that use me for more than one service and I give financial advice to those that ask without expectation of compensation. You are woefully educated about the myriad of sources of mortgage funding. You have been brainwashed by the big 5 into believing they have your best interests at heart and are the only entities to be trusted with handling your money. This is complete nonsense, many other “reputable” mortgage lenders exist that have long track records and provide unique mortgage structures for those people that can afford a mortgage but whom the big five deem “too risky”.

I’m sorry but this is some of the worst advice I have read so I felt I must comment.

1. I agree that variable mortgages do usually win, but do you really think that remains true when we are starting from a base of the lowest interest rates in history?

2. High interest rates are driven by inflation. Long term inflation comes from one thing: an increase in the money supply. Yes demand for housing such as in the 80’s can create short term inflationary spikes but long term it always comes down to money supply.

3. The monetary base has increase substantially during the credit crisis. Check the central bank website.

4. Most people can’t afford a 2% – 3% increase in interest rates. Most economists forecast the central bank increasing rates by at least 2% in the next year and wouldn’t be surprised to see a 6% – 8% overnight lending rate to curb inflation in the next few years (mortgage rates will be substantially higher then).

5. The credit crisis was brought on by people getting into variable or short term mortgages that they could not pay when interest rates rose (and many people lost their homes). Now you are telling the people in Canada to do the same thing.

Unless the central bank starts raising rates fast we will have a housing bubble in Canada which will end the same way it did in the states.

I think it is scarey that you are telling your readers to all go variable.

I like your chart. Comparing prime over the following 5 years to the discounted 5-year fixed is a better comparison than most studies. However, you should probably discount the variable, as well, shouldn’t you?

The rates we were accustomed to for quite a few years before the crisis were prime -.85% (discount varied between .8%-1%), and of course there was always a significant discount off the fixed mortgages as well.

If you reduce the prime line on your chart to prime -.85%, then variable has been cheaper except for a short period in the late 80s and one in the late 70s.

I hear your comments about risk and that some people really can’t afford to pay more. I used to think that way as well, that most people in good financial shape should go with the variable or 1-year, but people that are barely scraping by and cannot afford a higher payment should stick with the 5-year fixed.

But then doesn’t that mean that those that are in the worst shape must pay the thousands extra in interest? Shouldn’t saving money be even more important for them?

This is your issue of “cost certainty”. But do you not also get “cost certainty” with a 5-year variable, since most keep the payment the same regardless of interest rates? In both cases, you have certainty of your payments for the 5-years, but you also get a 90-95% chance of saving money.

You are right that there are occasionally times when the 5-year fixed saves money, but they are very rare and hard to identify ahead of time. Even with the very low fixed rates last month, it could go either way. But if you take an open variable, you also have flexibility and negotiating power, while still having “cost certainty”. Even if you don’t save money, you get all those other important benefits. Isn’t that the best of all worlds?

We have good contacts for all the mortgages that work well for the Smith Manoeuvre, except we have always struggled with our mortgage broker contacts, who were so often focused on long term fixed mortgages or variable only in a long term closed.

We sincerely believe in always taking either a 1-year fixed or an open variable (with a deep discount). Our clients often have issues where the flexibility is important. Since many are doing the Smith Manoeuvre, the flexibility and negotiating power are even more important, since we need to be able to keep the tax deductible portion separate and because we can usually get a free appraisal every couple of years to free up more equity.

This is a very important issue, since mortgage interest is very often the single largest expense. We see our role as always providing real advice (not just explaining options) and always advising what we would do ourselves in their situation.

This is why we are passionate about this issue. We see so many people make their mortgage decision emotionally based on a vague fear of a huge interest rate jump, without thinking about how unlikely this is and how much it costs them. Nobody seems to explain to them about the importance of flexibility and negotiating power, and that they can get cost certainty with an open variable.

Your suggestion of a capped 5-year variable sounds intriguing, since it solves the exaggerated fears people have about a huge interest rate jump. However, you said your rate today is 2.9%. Aren’t variable going at prime -.5% today, or at 1.75%? Does that mean you are paying the 1.15% for the insurance provided by the cap? Wouldn’t that lose most of the advantage of being variable?

It isn’t my chart. It was produced by CMT and a time when there was no discount to Prime available. You are right, if you take current discounts to Prime, you will have slightly fewer periods where fixed pays off.

But that doesn’t negate the fact, as you admit, that there are periods where the variable rate isn’t the most advantageous.

You say: “Even if you don’t save money, you get all those other important benefits. Isn’t that the best of all worlds?. To which I’d say: “No, not if you don’t need those all those other benefits but you do need to prevent losing money”.

Many of your clients require flexibility. Great! Then a VRM is right up their alley. But many other people have no intention of moving, have stable jobs, are not interested in leveraged investing like the Smith Manoeuvre, etc. They don’t need flexibility, so for them it comes down to how much per month they can afford to pay.

And you say: “But then doesn’t that mean that those that are in the worst shape must pay the thousands extra in interest? Shouldn’t saving money be even more important for them?” To which I’d say: “In an ideal world, of course. But in the real world, sometimes you need to pay for insurance — you need to pay a little bit of money to ensure that you don’t lose a lot of money. Usually this ends up costing you money (see car insurance, life insurance, home insurance that most people don’t need to claim). But sometimes you do need to use that insurance, and it prevents catastrophic loss (see car insurance after an accident causing death, life insurance after a death, home insurance after a tornado). It is simply reality that the people with the least amount to lose are often forced to pay more in order to protect it — simply because if they do lose what they have, they have lost everything.

So, yes, flexibility is fantastic . . . if you need it. But why should you pay for it if you don’t need it?

Likewise, cost-certainty is fantastic . . . if you need it. But why should you pay a premium (i.e., fixed-rate mortgage) it if you don’t need it? Go for a VRM.

Speaking of “cost-certainty”, I guess we have a different definition of what that actually means. Just because you can fix your payments with a VRM, doesn’t make it “cost certain”, because rates can always rise higher to such an extent that your payment no longer even covers the interest, at which point the lender will raise the payment. That means your payments are, by definition, uncertain. It is also commonly the case, as I noted above, that fixed payment VRMs are closed (see National Bank as an example) rather than open — so you lose the flexibility anyway.

Even Milovsky’s research shows that VRM are only better 85-90% of the time.

Again, I have no problem advocating for VRM. I think that they are vastly underused, and that most people would probably benefit from them. But I think it is irresponsible to claim that they are always preferable to a 5-year fixed rate, because that involves ignoring the 10-15% of the time that it doesn’t pay off. And in some of those cases, “not-paying off” isn’t simply a matter of losing a bit of money, it can be catastrophic. See Sarlock’s comments above for one case-study.

You raise some good points about rates rising and the risk of inflation. Really high inflation is the one big risk where short or variable would not work.

Interest rates were very low back in the 1950s and rose most years from the 50s through the 70s. However, variable still quite consistently saved money.

The reason for this is that 5-year fixed rates are always based on bond/GIC rates which are based on the expectations in the market for rates over the next 5 years. Therefore, when rates are expected to rise, the 5-year fixed rates will be higher.

Interestingly, the very rare times when 5-year fixed saved money were times of falling rates – not rising rates! Therefore, the spread of 5-year rates over variable or 1-year was lower. Then a brief economic shock resulted in a short blip up in rates.

Periods like this when rates are very low and expected to rise have historically been the most consistently in favour of variable or short term mortgages.

The inflation risk is interesting, since we have had massive deficits and there is a threat of Peak Oil, which could result in very high inflation. Both risks don’t really have a good historical precedent.

There has been a lot of talk on the internet about expectations of very high inflation. However, current expectations in the bond markets show really just a return to normal interest rates.

We think the inflation fears are quite exaggerated. The world economy is recovering and normal growth is returning, the huge government spending on bailouts will peter out, and Peak Oil seems to be a bit farther down the road.

Many people fear the really high rates that we had in the early 80s will come back, but that is extremely unlikely. Rates were only jacked up then because we had had more than a decade of stubbornly high inflation and that was the one way to finally start bringing it down.

If we have a decade of very high inflation, then I’ll start worrying.

The real reason we don’t expect high inflation is because of the powerful forces pushing it down. Inflation and interest rates have declined almost every year since 1982 for several reasons that are continuing.

The powerful forces pushing down inflation are globalization, technology and demographics. Globalization and free trade allow us to keep finding less expensive places to import from. Technology brings down the costs and makes products far more effective.

Demographics are dominated by the aging Baby Boomers that helped drive up rates in the 70s and early 80s when they were first time home buyers. Since then, the buying demand has declined and with the Baby Boomers now in their late 40s or 50s, their demand to buy real estate will continue to decline for the next several decades, as long as they are they dominating demographic force.

Of course, immigration partly counteracts this, as do their children (the Echo generation), but the Baby Boomers are still the main force.

These 3 forces are just a part of the overall complex economy, but they will continue to moderate inflation for the next couple of decades.

This is why we think the fear of very high inflation is exaggerated and the far more likely scenario is for rates to normalize.

We have been recommending either 1-year fixed or variable rates since the early 90s, In the last decade, we have been getting mortgages between 4-5% almost all the time. This is the 3rd time we dipped below 4% and there was one brief time where we peaked above 5%. The highest rate in the last decade was 5.4%, which lasted for only a few months. The average has been somewhere around 4.5% or a bit lower.

Our thinking is that rates will normalize as economic growth recovers. We might get a brief spike of higher rates, but most likely rates in the next while will be normal – or lower because of the powerful forces keeping inflation down.

I admit that inflation and interest rates are very hard to predict, but all the hype about inflation fears seems widely exaggerated to us.

I guess our view is largely because we were working for a few years with a 3-year open variable at prime -.85% that had a fixed payment for the entire term. There was a brief period when rates rose enough so that for a few clients their payment did not even cover the interest, but the bank did not change their payment even then. The mortgage balance actually grew slightly during that period.

So, we had complete cost certainty, plus we still had an open mortgage, so we could change anything if necessary.

That product has disappeared during the crisis, but we have been recommending 1-year fixed for the last 1 1/2 years anyway. Once rates normalize, we are hopeful it will return or that another institution will offer such an excellent product.

Ed, the “variable” rate in the capped version is a hybrid rate obviously, not the rate available in a pure variable. Still, my point is their are a host of options besides those most people seem to be talking about. Sometimes you pay a little more for “insurance”.

My point is that the “safe” option is the variable mortgage – not the 5-year fixed. There are 2 risks categories and variable is as safe or better on both.

Let’s compare a 5-year closed fixed and a 5-year open variable.

The risks are:
1. Payments increase because of higher interest rates. – This is a tie. Whether you take a variable or a fixed, your payment stays the same.
2. Financial issues in your life. – Variable is the clear winner because you retain flexibility and negotiating power.

If you lose your job and need to reduce your payments, you can renegotiate as low as 35 years amortization, while you might have forced higher payments with the fixed.

If you have unexpected expenses, you can refinance them into your mortgage at the lowest rate if you have a variable, but you might have to wait years until your mortgage comes due. Meanwhile, you might be forced to continue to pay higher interest rates on your credit line or credit cards.

If you decide to move, you have no issues with a variable, but might have to pay a large penalty with a fixed.

I think this is exactly the right time to be giving this advice. People are even more likely to fall into the 5-year fixed mortgage trap today than normal.

I do agree with you that the best choice now is probably the 1-year fixed, not the variable. At 2.15%, there is a definite savings over the 5-year fixed that the 5-year will likely not make up during the following 4 years.

The variable at prime -.5% is at 1.75%, but is widely expected to float up, quite possibly as soon as June. With only the first 2 quarter-point moves, the variable will be higher than today’s 1-year and it appears that a move of .5% is quite likely in less than 6 months, so the variable would be higher for most of the next year.

We like to always give advice and not just offer options. Our advice today is to go with the 1-year fixed.

The risks are: 1. Payments increase because of higher interest rates. – This is a tie. Whether you take a variable or a fixed, your payment stays the same.

Sorry, I can’t help but chime in one last time.

You keep claiming that variable rate mortgages and fixed rate mortgages are the same with respect to the risk of “fixed payments”.

This is absolutely not true.

First, In 90% of VRM mortgages, this is not how it works. Payments fluctuate with prime — at least if prime rises to a point where your payment doesn’t cover the interest.

Second, even if you might be able to find VRMs that let you keep your payments the same month to month, even if you are no longer covering the interest payments (although as you admit, these are not currently available), this is fundamentally not equivalent to a fixed rate mortgage where you know exactly how much of your payment is going to principal.

If the example you gave above, having a fixed payment VRM can even result in your mortgage increasing rather than decreasing, if rates were to rise substantially!

This is an added risk that Does Not Exist with fixed rate mortgages. With fixed rate mortgages you know exactly how much principal you will pay off at the end of your 5-years. With a VRM you do not know. Usually you will come out ahead, but sometimes you will not..

Consequently, in my view, it is misleading and even borderline irresponsible to claim that “it is a tie” or that “FRM and VRM are the same” with respect to this risk. It is absolutely 100% false.

Sorry, I just can’t let this go, because I think you are not being fair with the numbers.

As for the 1-year fixed . . .this isn’t for everyone either, because of the risk of a large drop in home assessment value, which then makes renegotiating difficult or, in some cases, impossible.

Homes in most large cities in Canada have seen double digit drops in value. This means huge drops in home equity. It could bring people below the 20% needed to avoid CHMC insurance, which would then add to the mortgage. In some cases, it could drop people underwater which, if you have to renegotiate, would not only take away a lot of your negotiating power, but it could mean you can’t get a mortgage at all!

With a longer term, you are less at the mercy of short-term property drops, simply because you will have paid off more principal.

One size doesn’t fit all — and that is especially the case with VRM and short fixed terms. You need to be able to accommodate the risk of large rises in prime, large drops in property value, or both.

Some people have a legitimate concern about the risk of the payment increasing, because they can’t afford an increased payment. That is a legitimate concern for some people that may be more important than saving money.

However, why is knowing exactly how much principal they will pay off important? We have never met a client concerned about this. The have a 90-95% chance of saving money and having a lower balance owing after the 5 years with the variable.

I can tell you there are mortgage providers that will keep the mortgage payment the same through the entire term – even if the payment is less than the interest. Our contacts for variable mortgages have this, so it is definitely available.

The 3-year open variable with fixed payments that we like so much is still available – just not in their Smith Manoeuvre mortgage. We really hope they reintroduce the Smith Manoeuvre version. It is still available, though, and we have a provider for a 5-year closed variable with fixed payments for the entire 5 years in a Smith Manoeuvre mortgage.

I would say, therefore, that the 5-year closed variable is equal in risk to the 5-year fixed. In both cases, the payments will be the same for the entire 5 years and they can be lower with the variable because they are based on today’s 1.75% rate.

In fact, the 5-year variable is probably still safer, because if something happens in your life – you lose your job, need to refinance or move – variable mortgages usually have much smaller penalties than the 5-year fixed.

At the end of the 5 years, they will probably owe less than if they took the 5-year fixed (if they have the same payment), but in the unlikely event that they owe slightly more – who cares?

This is especially true if they take today’s much lower payment based on 1.75%. Then they will probably owe more at the end of the 5 years, but they had the lower payment for the entire 5 years.

The 3-year open variable only has the fixed payment for 3 years, but maintains flexibility and negotiating power, so that may or may not be “safer” than the 5-year fixed – depending on which risk is more important for the client (risk of payments increasing or risk of changes in their life).

Also, I don’t really see the risk related to a large drop in property values. Our mortgage contacts don’t ask for an appraisal on a renewal. They also don’t reduce the limit on a secured credit line on renewal.

Back in the 90s when real estate in Toronto plunged by 30%, the banks did not reduce the limits on secured credit lines or ask for appraisals on an ordinary renewal.

A large drop in property value may affect your negotiating power if you can’t qualify at another bank, but we have never seen it be an issue on a straight renewal.

I agree that 1-year fixed is not equal in risk to the 5-year fixed or variable, but we believe that is the best strategy today to save money, until the larger discounts are available with variable mortgages.

As further evidence that the 5-year variable is the safe option, we believe that probably at least 80-90% of mortgage foreclosures are on people that have 5-year fixed mortgages (or longer). We have never seen a statistic on this (perhaps you have?), but the people we have met that are in a huge problem and considering walking away from their home are always in long term fixed mortgages. I can’t actually think of a single exception to this.

The reason for this is that, if things really go bad and you lose your job and can’t make your mortgage payments, then variable mortgages usually have a penalty of only 3 months’ interest, so in most cases you can still sell your home, pay the penalty and get out okay.

With a 5-year fixed, you can often have a much larger penalty – so large that you may have to pay money on top of selling your home to get out. The large penalties are not only when interest rates have dropped, because some institutions will charge you a larger penalty if the posted 5-year rate at the time you took your mortgage is higher than the posted 2-year rate today (if you have 2 years left in your mortgage). Each institution has different ways of calculating their mortgage penalties.

So, even with flat or slightly increasing rates, you could end up with a large penalty to get out of the 5-year fixed.

It is so strange that most people mistakenly think the 5-year fixed is safe, when I’m sure that is the mortgage held by the vast majority of people that lose their home in a foreclosure!

In short, we still believe that the variable mortgage is the safe option. You have the same payment for the entire 5 years that you would with the 5-year fixed, plus you can have a much lower payment for the entire 5 years. If things go badly for you, you quite likely will have a much smaller penalty and therefore a much smaller chance of having no option other than to have your home foreclosed on.

For those trying to save money, the 5-year fixed is probably never the best option! The best choice between the 1-year fixed or the variable would be expected to save money in virtually every situation vs. the 5-year fixed, plus you can usually maintain your flexibility and negotiating power (which can be a huge factor).

I realize from all the comments above that, yes, I can’t say completely that the 5-year fixed is wrong 100% of the time, but I have to admit that it is hard to come up with even a theoretical situation where we would even consider a 5-year fixed.

In short, for those people that want the safest option, they should go with the 5-year variable (with a fixed payment). For those looking to save money, they should consider each year whether to take a 1-year fixed (today’s best choice) or a variable (especially preferring an open variable).

So I’m in a BMO Readiline (prime plus 1) right now and am worried about the interest only payment rising when prime goes up (as we are on a single income). I pay the interest only on the first of the month as well as $200 bi-weekly. It seems like the $200 payments just zero out the interest only payment and that I’ll be at $185,000 forever! Should I close this Readiline and move the $185,000 to a 1 year fixed? I’m so confused…I was thinking of moving it to a 5 year fixed but clearly this forum is changing my mind.

At the end of the 5 years, they will probably owe less than if they took the 5-year fixed (if they have the same payment), but in the unlikely event that they owe slightly more – who cares?

This is especially true if they take today’s much lower payment based on 1.75%. Then they will probably owe more at the end of the 5 years, but they had the lower payment for the entire 5 years.

Are you serious!?? You seriously don’t see a problem when people take a mortgage that they make 5-years of payments on AND at the end of those 5 years owe MORE on their mortgage than when they started? Seriously?

Who cares how much you owe at the end? It is all about monthly payments? Holy smokes, Ed! That is about the craziest thing you’ve said yet!

And if you claim that you can’t think of any situations where lenders decline refinancing negative-equity mortgages or ask for appraisals at renewal, you are, again, being disingenuous or you don’t read the newspapers. This isn’t 1990’s Toronto. This is 2010 post-financial crisis. Google “Orphan Mortgages” for about 5 million pages describing it. And, no, it is not only with “sub-prime” mortgages.

So, just to sum, let me get this right.

You say “Who cares?” to a person who takes a 1-year fixed rate mortgage, whose home drops in value, and who, at minimum, now has to take on CMHC insurance because they now have less than 20% equity. And who, in fact, might have trouble refinancing at all, and will certainly not be getting the same rate that they did in the past.

You say “Who cares?” to a person who takes a five year VRM and who dutifully pays 5-years worth of fixed payments and then at the end of that 5-years owes MORE on the mortgage than when they started? Who then has to go to the bank to try to get another mortgage on a home for which they have negative equity. And you are claiming that the Banks are fine with this. That they will just turn around and negotiate with you no problem. Heck, they will not even ask for a new home appraisal and will offer you their best rates?

Come on, now.

Your mention of the number of defaults is also problematic. I don’t have the statistics, but it makes perfect sense why 5-year fixed would have more defaults than VRM. First, more people have fixed than variable, so all things being equal, they should have the most defaults. Second, VRM tend to be taken by people with more equity and higher incomes, making them less likely to default. Third, until last week, you could qualify for a fixed mortgage with a much lower income than you could for a VRM. Again, this necessarily leads to more fixed rate defaults.

None of those factors have anything to do with the fixed mortgages being “riskier”. They have to do with the fact that (1) more people sign up for fixed mortgages than variable and (2) that VRM mortgage holders tend to have higher equity and higher incomes than fixed rate holders, both because of socio-economic status (i.e., higher income people tend to be more comfortable with VRM) and by lending structure (i.e., it has traditionally been harder to qualify for a VRM).

trudy call a broker. there free and way more qualified than the banks “mortgage professionals.” i have no idea what product your in sounds like a line of credit not a mortgage. as you have read here prime +1 on a variable is a really bad deal. a broker will act in your best interest and that just doesnt seem to be the case at the banks. i personally really like the capped variable mentioned in one of the other posts .if the #s posted are correct thats the way i would go unfortunately thats not an option for me. check out toms posting #59

I’m not sure what mortgage you have from your description. You can have multiple mortgages and credit lines in a BMO Readiline.

It sounds like the interest only you are paying is on a credit line portion (prime +1%) and the $200 bi-weekly might be on a mortgage portion. Is that right or is it all a credit line, Trudy?

If you are at prime +1%, you must have refinanced something or have a different product, since BMO left their Readiline at prime for those that made no changes.

Is your priority trying to save money and make progress on paying down your mortgage, or is your priority to just keep the lowest possible payment that won’t rise above a certain amount so that you won’t lose your home?

You can keep the Readiline and convert the credit line portion to a mortgage. BMO is a bit high right now at 2.39% on a 1-year, but our recommendation to save money would be to take the 1-year. That is already quite a bit lower than the 3.25% you are paying now.

The variable is a much lower rate and payment today, but we are waiting for the deeper discounts from prime before taking a variable. We are waiting for prime -8% to -.9%.

There are cheaper 1-year fixed available at 2.15% today, but we would need to know the details of your situation to be able to tell you if moving would save you any money.

I hope this helps, Trudy. If you want a specific recommendation, feel free to call our “Ed’s Mortgage Referral Service” offered on MDJ. Just email us your answers to the 10 questions and one of our advisors will call you with our recommendation and referral to our contact (if necessary).

Don’t forget the other reason why almost everyone that is foreclosed on has a 5-year fixed. Because they are trapped! They may have a huge penalty that they can’t afford, so there is no way out!

If they have a variable or 1-year mortgage, they can almost always sell and get out their equity and avoid foreclosure in a worst-case scenario. In a 1-year, it always comes due in less than a year and then there is no penalty. With a variable, the penalty is usually far smaller than with a 5-year fixed.

Yes, I say “Who cares”. Have any of those things actually happened to any of your clients, bob? We have never seen any of those issues and none have ever happened to any of our clients.

Maybe it is just our process. Our clients call us when their mortgage is coming due to get our advice. Then they talk to the bank. Our contacts give their best rate to anyone we refer, even on a straight renewal. We have hardly anyone in bad shape financially, but even those with no income or equity have been able to get a straight renewal at a good rate.

We don’t deal with fly-by-night mortgage provides, so orphan mortgages are not an issue for us either. I read stories in the paper, but they just would not be an issue for us.

I recognize that you are concerned about your clients and your clients perhaps are not likely to be there on renewal like ours, so our advice may differ because of that.

We do find that 5-year fixed mortgages are usually sold by vague references to fears that are not an issue or can easily be resolved, or to worst-case scenario situations. What happens if real estate plunges 30% AND I lose my job AND interest rates soar at the same time AND banks change their policies so that they don’t do straight renewals any more??? What happens then???

Instead of focusing on fear, we just advise people on what seems to be the smartest thing for them.

Most people just want to save money. They should avoid 5-year fixed. Take whichever is better between 1-year fixed or variable because it will almost definitely save them money. Plus maintaining flexibility and negotiating power can save a lot more money.

Some people are extremely tight financially and may lose their home if payments rise. They should take a 5-year variable with a fixed payment. This will give them the lowest possible payment that can be fixed for the entire term and they can avoid being trapped by a huge penalty.

We have not yet come across a single situation or client in 15 years of talking with clients about mortgages where we thought a 5-year fixed was the smartest choice.

Trevor why on earth would you limit yourself to the big 5 banks. the terms of your mortgage contract is the only thing that should concern you. even if the corporation that held your mortgage went bankrupt it would not affect you.your mortgage would be sold to another institution or possibly continue to be held by the same institution in a restructuring of their debt.as for national bank they are indeed canadas 6th largest bank conducting most of there business in quebec. if your not in quebec perhaps their lack of branches could be a very minor concern. i have only dealt with national bank on one occasion and almost fell of my chair when a real human being answered the phone.

The purpose of my comments in regard to National Bank was the fact that Tom felt it necessary to bash Canada’s big 5 banks by stating that the banks “never offer their best rate up front” This statement simply is not true, nor has been been for some years. That rates advertised on each FI’s website show that most of the banks offer very competitive rates up front. Can they be lowered even more…?? probably. You will never find any institution which gives their drop dead lowest rate. I deal with clients on a daily basis and have worked in the industry were many years. I have heard stories of the service that brokers provide clients. Mortgages that are not portable, can’t refinance, fees to change payment accounts, fees to change payment schedules, no service from broker after fees have been paid… the list goes on and on. Now don’t get me wrong, there are good brokers out their as well as bad.

Their is a good reason why the Canadian banking system is the envy of the world. Canadian banks have survived and grown during one of the worst periods in our history.

We don’t get paid any more based on the term you choose for your mortgage. To be honest, and I have stated to clients the same thing. I don’t really care which term you choose for your mortgage. It is my job to ensure clients understand the risks they assume based on the selection they make. And it is the clients choice. I strongly believe, as I have stated before, that variable rate mortgage in todays rate envirement is a very risky choice to make. Clients are going into a product linked with prime when prime is at one of the lowest it has ever been. The bank of canada as well as every economist that ever speaks is not wondering if prime would increase but when. Why then would you lock a payment in on a mortgage knowing 6 weeks prime WILL increase.

My suggestion to those who are still considering variable is to do so, but set your payments to what they would be, if you locked in for 5 years. This will at least protect your amortization from inceasing as prime goes up over the next 18 months.

billynuh please fully explain the relationship between bond prices and fixed mortgage rates. my somewhat limited knowledge on the subject is as follows.banks tend to hedge mortgages by purchasing bonds.prime goes down bond prices go up as does the cost of their hedge.they cover this cost by increasing fixed rates and briefly prime and fixed rates can move in opposite directions. as to watching prime rate as a trigger to lock in its because i believe prime and fixed rates could be going up a lot faster than most people predict.

Ahhh, I think I see the problem. You seem to confuse your clients, who, by the look of your website and the types of services you offer (e.g., Smith Maneuver, etc.) are almost certainly atypical, with the bulk of people who get mortgages.

What is right for your rather specialized clients, is not necessarily right for everyone, which is why offering generalized blanked statements on a blog (e.g. “VRM are always better than FRM”) is so problematic. The readers of this blog (see Trudy’s comments above) are very unlikely to be the same demographic as your clients.

Mortgage arrears have been increasing across Canada despite the fact that we have been in a rate-dropping environment.

I guess we will see over the next two or three years how people in VRM deal with the increasing rates and decreased property values. I suppose it is great that they will be able to avoid penalties in order to sell their homes at a loss . . . but I think most of them would rather be in a position where they didn’t have to sell their home in the first place.

The stats are not available in Canada, but we do know in Australia, where the vast majority of mortgages are VRM, that delinquencies spiked in 2008 as the Bank increased rates. They have also risen with the latest rate hike schedule in late 2009 early 2010.

Will that happen here? Tough to say. We have fewer sub-prime lenders, tougher qualification standards, different tax regimes,etc., but it is worth noting that the Bank of Canada was worried about it enough to issue a rather unusual statement calling for lenders and borrowers to be responsible when accepting the current low rates, and the Government of Canada was worried about it enough to change lending regulations to require borrowers to qualify at posted rates rather than discount rates.

I like optimists, and I hope you are right. It would be terrific if we could all just take VRM and not have to worry about whether our homes increased or decreased in value, whether rates rise higher than our payments can cover, or whether we go into negative-equity positions. Who cares, right!

But, I rather think that all of those issues are not imaginary risks, that they all have consequences, and that we really ought to care.

Trevor, so the banks posted rates are the best rate you can get, perfectly transparent? No bargaining, no dickering? Funny how I constantly hear from other mortgage brokers that they bust their asses to get a great rate for a client only to have the client go back to their bank and tell them they can get this great rate from ABC mortgage co. through their mortgage broker, then all of a sudden the bank can match this rate (only because they are loath to lose even one client!). I’ve also heard from financial advisors that their clients have been told they can get a “better” rate if they move their investments (RRSPs etc) to the bank. I for one am sick of the Big 5 and their predatory practices. I had one client take out a small sum to purchase some GICs and 2 days later the bank called her to see if she had a Financial Advisor and recommend she see one of theirs. I’m glad to say she told them to go to hell but it’s symptomatic of the system as far as I’m concerned. The banks care about nothing but their bottom line, not the well being of their clients. End of rant….

You better go back and read my post again… I simply stated that banks have been posting for some time now rates ranging from 1.00 – 1.55 % of posted rates. Can people get better rates than what is posted? I believe my post said they could. I am not sure why you are so angry. There is a reason why banks have been taking market share from the brokers business for years… and in some cases banks will not let brokers sell their product. I guess we don’t want to dilute our product from crappy advice like telling all clients to go into variable rates mortgages when prime is at historical lows.

Don’t you think you are missing the big risk – the risk of being trapped in a 5-year fixed? Every time you lock into a 5-year fixed, you take on the risk of having a HUGE penalty that can lock you in.

We have 3 clients in this situation today that I can think of off hand. One couple has 4 years left in a 7-year fixed at 6.99%. They cannot afford it. They have already maxed out their credit lines and are borrowing from their credit cards every month.

It is partly their fault for buying too much house and spending too much money. However, they now have a choice between 4 more years of scraping by trying not to borrow more than $500/month from their credit cards or paying a penalty of $35,000.

We did the math and there is no question they will save a lot of money by paying a $35,000 penalty to refinance, but they don’t have it. Their mortgage is already at 90% of their home value.

When I talk with them, there is panic in their voice. I feel for them. But there is nothing that can be done.

They will not be able to save for their retirement at all in the next 4 years. We advised that they sell their car and buy a beater. We discussed selling the house and decided against it.

They are truly trapped for 4 more years.

We have another couple with 2 years left of a 5-year fixed at 8.25%! Believe it or not. A mortgage broker stuck them into this. They also have zero extra money, can’t save a penny for retirement and can do nothing but scrape by until their mortgage finally ends.

We have another couple that moved into Toronto. They could not sell their prior home because there is a penalty of $23,000. After real estate commissions, legal fees and the mortgage penalty, they would have to write a cheque for $15,000 to get rid of their old house. They don’t have $15,000.

Their 5-year fixed mortgage has 2 years left at 5.99%.

Instead, they rented it, but have never been landlords before and are having tenant trouble. They listed the house for sale and hoped for a high price, but can’t sell it for enough to get out.

Their old house is an hour away and he must drive back and forth regularly to deal with tenant and repair issues.

But they are also trapped. The only option is to keep renting their house until their mortgage finally comes due and they can finally dump their old house.

These kind of stories happen all the time. People trapped in their 5-year fixed mortgages. All these people would be far safer with a variable, since the penalty would have been 90% lower. A $3,000 penalty would not be a problem for any of them, but penalties of $20-35,000 have them trapped!

When people take a 5-year fixed, they need to remember that they are potentially trapping themselves in a situation that they may not be able to get out of. They may well end up with a HUGE penalty to get out of it.

In the last 10 years, we have had at least 20 clients pay penalties of $10-30,000. All of them saved thousands by paying the penalty, because they could refinance at far lower rates.

Many were totally pissed at the size of the penalty. We had 2 clients that paid a $10,000 penalty 2 months after taking their 5-year fixed!

Our bias against 5-year fixed and the reason for this article is from the feeling of panic that we have felt from quite a few clients.

This is why we don’t think of 5-year fixed mortgages as safe. With a variable mortgage, the penalties are usually much smaller. With an open variable, there is no penalty at all. With a 1-year, the mortgage comes due every year and then there is no penalty.

The variable mortgages we have referred people to with fixed payments are with the big 5 banks and are available to everyone.

Many things can change in your life in 5 years. If there is any chance that you may want to move or refinance, in less than 5 years, then they are even more risky.

In addition to the 90-95% chance of paying thousands more in mortgage interest, the risk of being trapped in a 5-year fixed is one of the main reasons to avoid them.

All of which doesn’t answer the question: who are these lenders who will apparently allow an average borrower to have a VRM with fixed payments that will not rise even if the payments no longer cover the interest. I’d love to know so that I can look into it for myself.

I’m not ignoring the risk of FRM at all.

As I’ve said repeatedly above, flexibility definitely has value. If you need flexibility, don’t go with a fixed mortgage.

All I am asking is that you also acknowledge that cost-certainty has value too. And by cost-certainty, I don’t mean a fixed rate VRM in which you can end up owing MORE at the end of it than when you start. I mean certainty that your payments will not change and that you cannot end up in the hole as a result of interest rate hikes. VRM cannot provide this — no matter what flavour they come in.

I can understand the situation that your clients are in. Penalties are outrageous and they way they are calculated really is criminal… but that another article for sure. I completely agree with you that variable is more flexible. I wouldn’t say safer but flexible. But lets face it, the clients who run into financial trouble, lose their jobs, have unexpected illness’s in most cases are going to have to sell their homes anyway. And yes an open variable in those situations is much better with no penalty at all. I am sure you have seen it before, and there really isn’t much the broker or banker can do about clients rose colored glasses. They love that dream home, they max themselves out to buy that house that they really can’t afford and choose the term that provides them with the payment that can buy them the bigger home. But to say that variable is the best for all clients based on the 20 bad cases you have seen over the past few years doesn’t make a great deal of sense either.

I guess the new mortgage rules that will make clients qualify at a 5 year posted will solve some of the shock when renewals happen in 5 years and clients discover their amortization has increased drastically. At least the lender is assured that if the clients income and lifestyle is the same that they can handle the increase payment.

You also mentioned that if clients ran into unexpected expenses that they could easily add on to a variable and could not with a fixed rate mortgage. This is incorrect. If a client chose to add on to a variable in most cases their payment would then be recaculated at whatever the variable rate was at the time they refinance. With a fixed rate mortgage clients could also add-on quite easily with no penalty. New funds with both scenerios would be based on new rates and in both scenerios clients would have to qualify. There are also options in some mortgages that will let client bring the mortgage back up to its original balance assuming that their amortization does not change.

Negotiation – as far as negotiation goes, I believe the client with the fixed rate term has more negoitating power than someone in variable simply because the bank knows the the fixed rate mortgage isn’t going anywhere…. becuase of those astronimical penatlies!! VRM are riskier for banks because they are open. You can’t negotiate credit lines or credit cards based on the type of mortgage you have. You have to qualify for any additional credit you have regardless of the mortgage you currently have.

I know what you are talking about and have run into some of the same predatory practices. There are laws against “tied selling”, but not against “cross-selling” or “relationship selling”. This is all a grey area.

As I understand the law, they are not allowed to say they will only give you a loan/mortgage if you move other business to them, but they can say they will give you a better rate.

Our bank contacts know better than to require any of our clients to move any of their other banking/investments in order to get a better rate, but I think this is very common when people go to a bank on their own.

We had one client that we referred to a bank for a 1-year mortgage in 2003. When the mortgage came due, the bank offered them a lower mortgage rate if they moved all their investments to the bank. All their investments are with us and we were the ones that referred the client to the bank in the first place!

We found the client a better deal with a different bank. Since then, we have referred clients that have done well over $100 million in mortgages. Zero went to that bank.

The banks do claim that you get a better rate if you have more products with them, but I don’t believe that is actually true. If you know how to negotiate, you can get a better rate. Banks will have a posted rate and when you ask for a lower rate, will offer a better rate.

But then if they believe they will actually lose the mortgage, they will offer an even better rate.

Even though we refer lots of clients for mortgages to banks, when we ask them what their best rate is, they don’t tell us their bets rate right off. Every time rates change, we call all our contacts and ask them what their best rate is now. Then we tell all of them what our lowest rate is and that dozens of mortgages are on the line. Is that really the best rate? Sometimes, we have to even send in a trial mortgage to see how low the pricing department will go.

Every single time interest rates change, we have to go through this entire exercise which usually takes about a week. Lately, it has been taking longer.

The lowest rate goes to those that can negotiate effectively. Our experience is that the number of products you have with the bank is mainly irrelevant, despite what they tell you. If they don’t offer their best rate because the client has no other accounts with them, then they will lose that mortgage to a different bank. Once they realize that, they offer their best rate.

I do feel for mortgage brokers working against banks. No matter how much work you do for a client, once the bank sees the mortgage transferring, they will often match the rate or offer .1% lower. This is often a much lower rate than they offered up until then.

We have seen some “crappy advice” from mortgage brokers (as you say), but in general I would say that advice from bank mortgage people is not any better.

Both mortgage brokers and banks tend to prefer long term closed mortgages because they make a lot more money on them. For example, today it seems that all the talk is about 5-year fixed or 5-year variable. Why would either one be a good choice today?

We think the best option today is 1-year fixed at 2.15% (until deeper discounts are available on variable mortgages), but the mortgage industry seems heavily biased against short term.

The clients I mentioned that are trapped in long term fixed mortgages with HUGE penalties mostly got them from mortgage brokers, but the worst ones (6.99% for 7 years) were from a bank mortgage person. The bank is making a ton of money while the clients are panicked about how they will survive until they can finally get out of their mortgage. We told the clients to never take any advice from that banker again.

People think the banker is on their side, but generally you are negotiating AGAINST them. The higher interest you pay, the more the bank makes. I’m not sure how their compensation works, but I believe even the bank advisors generally make more for offering smaller discounts. This is also true in some cases for mortgage brokers.

Of course there are many cases of good advice in both cases. The general tendency for both, though, is to lock clients into long term closed mortgages.

In both cases, based on stories we have heard from clients or what mortgage people tell us, we find mortgage people present 5-year fixed as the “safe” option. They say you might save money with variable – or you can take the “safe” option of a 5-year fixed so you know what your payments will be. Often they don’t even mention that the payments are usually fixed with a variable mortgage or that the 5-year fixed may mean a HUGE penalty. There is often a subtle push to take the “safe” option, even for people in strong financial shape. There is usually little attempt to quantify the odds and the savings, so that people would see how much better the short/variable mortgages are.

The advantage to the mortgage person of a 5-year fixed is that there are much bigger discounts available, so there is more they can say to make the sale.

It seems to us that people are offered the 2 long term closed options so that they don’t think about the 1-year fixed or open variable that are nearly always the smart choice.

You said you think that variable mortgages are “crappy advice” today. I’m not sure that is true. They are more than 2% cheaper right now, which is quite a bit. Today’s 5-year fixed is about 4%, which is barely below the average variable rate of the last decade. They were usually between 4-4.5%.

Our issue with variable today is that they are only prime -.5%. We aren’t recommending them until we can get prime -.8% to -.9% (and the 3-year open variable in a Smith Manoeuvre mortgage returns). If prime -.85% were available, we might be recommending it today.

Do you think that the “average” bank mortgage person offers any better advice than the “average” mortgage broker?

I was learning lots between all of the back-and-forth debates, until some of you started repeating yourselves and thus confusing me about the whole fact.
I try to take in the best knowledge that I hear, but its hard when there is such conflicts between 2 different strategies.
Each method has its postives, and its negatives.
What I learned originally from this article was that VRM are generally better at saving you money in the long-run if you stick to them and renew them.

Can a 5-year fixed beat it sometimes? can you possible save more money? can you pay off the mortgage a year faster perhapts? Sure.
Can you be a trader and buy and sell stocks to make a larger profit than the ‘Jones’ next door? Sure.
But why not just stick with the product that is working for you, and save what your able to save.

See, I just want to have the highest probability, and best chance, to save and accumulate as much money as I can; without paying large amounts to taxes.
So when I get a new mortgage, which will I choose?
I will choose VRM most likely, do to the fact that according to statistics, it has the highest probability to save me the most money long run and pay the least amount to interest.

Yes, that’s right. If you want the best chance of saving money, go with a Variable Rate Mortgage.

But, if you do so, just be sure that you are capable of absorbing at least a 4% rise in Prime. The majority opinion of economists is that Prime will jump by around 2.75%-3% between now and the end of 2011. After that, it is tough to know what will happen. Make sure you know what a 4% rise in Prime actually does to your payments. On a $250,000 mortgage with a 25 year amm, a jump from 2%-6% means your monthly payment would rise over $500 (from $1058.63 to $1599.52.). If that would be easy for you, then go for it. If that makes your palms sweat and means you’ll be living off of peanut butter and tuna, you might want to think again.

I see that as of today, the qualifying rate for a VRM is now 6.1% (if you are putting down less than 20%), which should help ensure that variable borrowers have sufficient income to deal with rate rises.

As noted by a few people above, a great strategy is to take a VRM but set your payments as if you had a 5-year fixed. In that case you:

1) are automatically protected against some rate hikes;
2) are automatically paying down your mortgage faster, because all of the difference between the amount you need to pay (i.e, the VRM) and the amount you ARE actually paying (i.e, the fixed rate amount) goes straight to principle;
3) are not paying a premium just to have your monthly payments fixed.

If rates drop (note that this is impossible at the moment), you pay the whole thing off even faster.

If rates rise, you are protected until it goes higher than the fixed rate at which you chose to set your payments. At this point, despite Ed’s comments, most lenders (we’re still waiting to hear who these other lenders are) will adjust your payment higher to make sure you at least cover the interest. Make sure you build this possibility (even if you think it is remote) into your decision, because the consequences of not being able to pay could be severe.

If you want slightly more comfort, take a capped variable. You will not get as good a Variable Rate, but you will still almost always be lower than the 5-year fixed, and you will not have the risk of payments rising higher than your comfort level.

And, yes, Ed is right. Currently the discount on VRM is much lower than it has been historically. So, if you figure you can afford a VRM, you might be better off taking a one-year fixed until the deeper discounts return.

Ed, thanks for the back-up on the predatory practices of the banks. Trevor, I never indicated I am pro or con variable. What I do for my clients is explain the differences between the various mortgage choices, how much each will cost them and affect their amortization etc. I also point out the benefits and risks of each option. Then I let the client decide what kind of mortgage they want. I would hope all brokers and bank reps are doing the same thing, it’s the ethical way to do business. BTW, I’m not angry with you, just a little fed up with the business practices of the banks.

For those people that want to save money, we would recommend to always look only at the 1-year fixed and the variable mortgages and then choose the best option.

Today we are recommending 1-year fixed for those trying to save money. We are only recommending variable for those that need the safe option and can’t afford higher payments.

Once we can get deeper discounts (prime -.8 to -.9%), then we might recommend variable, depending on what the 1-year is at that time. The 5-year closed variable is a long time to lock in. If we can get the 3-year open variable, that would most likely be our recommendation.

Bob summarized it well, except that we would probably never recommend 5-year fixed. The studies are not perfect, but show variable wins somewhere between 88-95% of the time, and 1-year beats 5-year 90-100% of the time.

If you take 5-year fixed regularly, then your chance of losing money is probably 100%. And the amount of money is huge! You lose during your life an average of $22,000 after tax for every $100,000 of your mortgage. If you have a $200,000 mortgage, how long do you have to work to save the extra $44,000 after tax???

For those that can’t afford payment increases, we have been getting mortgages from the major banks that are 5-year closed variable where they leave the payment the same for the entire 5 years, no matter how high rates go. That is the best of both worlds – probably save money, fixed payments, option of lower payments than you can get with the 5-year fixed, and you are not trapped by a potential huge penalty.

The reason that 1-year and variable win over 5-year fixed so consistently is because they are nearly always a lot cheaper at the start. The difference between their rates and the 5-year fixed rates are based on the bond market and bank’s risk analysis of the chance of rates going up and by how much. The bond market usually prices risk very well. Today, the variable is more than 2% below the 5-year fixed.

The bond market calculates rates so it always expects the average variable rate during the next 5 years to be less than the average 5-year fixed.

In general, we would always take an open variable over a closed variable. However, the options are somewhat limited.

Let me be clear, though. We are recommending 1-year fixed today. The link to this article from the Globe and Mail site states that we are recommending variable, which we normally do – but not today.

Today, we think the 1-year fixed is a better choice because we estimate it will save money during the next year, but more importantly we don’t want to lock in a 5-year closed variable with a discount as small as only prime -.5%.

Today, if you are going to take a variable, the open is definitely better because the discounts are only about prime -.5%. If you take an open variable, you can convert to a prime -.8% to -.9% as soon as they are available.

Most variables are closed today. The variable allows you to maintain your flexibility and negotiating power, which can be worth a lot.

A 5-year variable is the safe option if you are mainly focused on not being able to handle an increase in payments.

The 3-year open variable we have been using for clients that want to do the Smith Manoeuvre is not available in a Smith Manoeuvre mortgage today, which is part of why we are recommending the 1-year fixed for them. That was a great mortgage and we really hope it returns. We might be sticking with 1-year mortgages if it does not come back. In our process, 5 years can be a long time to give up so much flexibility, so we would be hesitant to take a 5-year closed variable for the Smith Manoeuvre.

My advice to everyone is to take Ed’s opinion as well as a couple of others. Go to a broker, go to a banker. Make sure you know what the broker is making off you as well as the banker. Do they make more off short term rates or long term rates. You deserve to know and are well within your rights as a consumer to ask!! Make sure you understand the risk of all types of mortgages. Ask lots of questions, get all the information you need, and be sure the decision YOU make is yours, and is in the best interest of you and your family. Your home is one of the largest purchases you will ever make. Do it with caution.

Good advice. I’m not sure which financial planner you are referring to. I only said the 3rd quote you mentioned.

You bring up a point that I don’t know the answer to, though. Do consumers have the right to know how the banker’s bonus is calculated so that they know how their pay will vary depending on which mortgage they recommend?

I think this is one of the rare cases that having a 5 year fixed mortgage will actually pay off for you. Assuming of course you were locked in before the recent hike increase at the end of March. As you said the 5 year is based on the bond/GIC rates which generally have a good feel to where the market is going. Since the banks have been increasing rates (twice in the last 30 days) you would expect that they are leaning towards a faster/higher increase in rates. The market is expecting a 1.25% increase by the end of the year.

If you were locked in at the 3.75% rates that were offered you would be paying 2.00% higher that a VRM right now (2.25% minus 0.50%). Assuming the market is correct after 8 months you are only at 0.75% difference and IMO in for one of the few times you might actually loose in going with a VRM.

There are questions in this whole thing that might prove me wrong:
1) the banks are still playing games and are artifically moving there numbers around to introduce a fear into the market that will cause people to lock in
2) the US will not move their interest rates at all, forcing Canada to become less aggressive in there interest rate hikes in order to keep the dollar from rising to rapidly and destroying the export industry

Here is a follow up with a simple analysis on a $100000 mortgage where your VRM payments increase as the rate increases.

Now this is assuming VRM rates as follows:
In line with the expected 2% increase over the next 2 years and 1% over the following 2 years. Could be higher and could be lower but for argument sake let’s use this information:

Now anything could change, rates could increase/decrease the discount on the VRM could increase. This is something that we will never know until time passes but as you can see the difference is very little. But this only holds true if you have already locked in your rates. If you haven’t you would want to run your numbers and do a little comparison to see where things will stand for you.

Paul what makes you believe the boc cares about a high Canadian dollar. does everybody forget Mulroney Wilson and Crow. Immediately after negotiating the free trade deal they bumped interest rates 50% higher than the American rates triggering the worst recession that i can remember.

You could be right. This is one of those very rare times when it may end up that the 5-year fixed did NOT lose money. There are enough unknowns that we can’t know for sure.

The 1-year fixed is more likely to be the winner of the 3. Considering it will be a lot lower for year 1, it is unlikely to go high enough and stay there to cost as much as today’s 5-year fixed. See post #54.

If we had the variable discount of prime -.85% that was available for several years before this crisis, then the forecast would not be as close.

Even when it looks close, things usually turn out against the 5-year fixed, so I would still hesitate to take it. Going with a 1-year or an open variable today will maintain your flexibility. Then you can take whichever is a better deal next year. With this process, I think you will still likely end up with significant savings.

This may all be mute, though, since it looks like rates are going up again tomorrow.

Paul,
I believe eventhought the differences are minimal on a 100k mortgage, you have to take into account that if you only have 100k mortgage you don’t have a whole lot to worry about.
Truth of the matter is, probably 95% of buyers getting into a new mortgage today, would have a minimum of 250k.

Does that not mean that:
Total interest payments: $16,418.63 $17,101.08
Since that is based on 100k, how about the difference in a $250k mortgage?

It’s rediculous. People will wait for gas to go down .03/L to fill up, search for coupons in flyers, pay memberships to shop at costco. But will they spend an hour a year to save hundreds, if not thousands, on interest?
Or learn to negotiate when buying a car to save thousands?

Strangely enough, most people ‘can’t be bothered’. But time is money, and I am all for using my time efficiently.
(Just my opinion – state yours if you dont agree)

I haven’t gone through the entire series of comments here but two things to note:
1. If you are paying paying a lower interest rate when your principle is high, which would be the case right now if you start your mortgage term, it is a positive for VRM or short term fixed mortgages, so its not quite a linear equation (directed at post number 45).
2. Discussions on interest rates should consider the opportunity costs of what you can make with other investments. I think one shouldn’t be too aggressive in paying off mortgage, if you can save a few hundred dollars a month by not going fixed and use that money to invest in equities and the stock market to get yourself a 10% return, then that option makes sense – again i know there are risks to doing this but i firmly believe that if you do this over a relatively long time period you will end up ahead. In mid 2009, i refinanced my condo for a 35 year amortization (@ prime -.75) from a 25 year mortgage, i was in a biweekly accelerated payment plan before, paying about $1150 for mortgage now i pay only $450….this money that i have used for stocks has already got me a 100% return. I will at some time put down a lump sum payment on the principle on the mortage from this extra money i have made, which wouldn’t have existed had i just blindly peddled my money into a mortgage.

At the end investment decisions should be tailored to ppl’s needs/desires and risk tolerance. While the math is unequivocally on the side of VRM, the peace of mind that ppl get from having certainity of a fixed mortgage might be worth the extra money.

What a way to get feedback – take something 70% of the population does and knock on it.

While I agree with the most part of your argument Ed, my problem is with ‘probabilities’. Instead of trying to find patterns and identify what circumstances would result in 5-year fixed mortgages doing better than the 1-year & VRM strategies, there is constant reference to 90% of the time.

The chance of VRM beating 5-year fixed is not always 90%. Depending on the spread among rates, and the economy – hence direction of short-term bond fluctuations, the actual probability today vs. 3 months from now, vs. 6, vs 24 months from now is always fluctuating. The 90% is more a proportion of the time when VRMs beat FRMs, not a probability. Maths are being slightly misused here.

I do agree that 5-year fixed rates are lower ‘risk’ – risk being defined as standard deviation of principle balance at the end of 5 years. Whether money is saved or not, there may be variability in the ending balance with a VRM – hence higher risk.

Good point. 5-year fixed mortgages are like cheering for the Leafs to win the Stanley Cup! The odds are massively against you, but most of us do it and get kind of a good feeling about it.

The Leafs have won the Cup only slightly less often than 5-year fixed have saved money over BOTH 1-year fixed and variable mortgages.

If we thought about it, there are many much better teams that are far more exciting to watch (think Pittsburgh, San Jose, Vancouver..) and don’t forget – far more likely to win the Stanley Cup.

We could watch really closely and try to guess the one year that they might win, or we could bet on them NOT winning.

The problem with trying to figure out the odds is that the times when 5-year fixed actually work are usually when they are leas expected to. For example, in 1987 rates were trending down and then there was an unexpected crisis that bumped up rates.

So, if you always decide only on 1-year fixed or variable, you will likely beat 5-year fixed nearly every time – and over time you will definitely save thousands.

Just like betting on Leafs. If I bet against them winning the Cup, I might be wrong once in the next decade or 2, but if you bet against them regularly, you’re definitely going to win.

I agree completely! People get upset about paying more for gas, but the money they waste by taking a 5-year fixed over a variable on average is roughly equal to a full year’s gas tank fill-ups!

The average Canadian wastes $2-5,000/year on average by taking 5-year fixed mortgages, which is roughly the cost of filling up their car all year!

If you never take a 5-year fixed, the money you will save over your lifetime will probably pay for a vacation every year!

If you spend an hour renegotiating your mortgage each year, that is likely the single most profitable hour of your year!

That is why 5-year fixed mortgages on our list of the 4 things Canadians waste the most money on. If your cash flow is very tight and you want to save a lot of money, the 4 easy ways to save thousands are:

Ed, you missed my point and are distorting it completely. To use the hockey analogy, you are saying betting on the leafs is bad going into the season. But what if they suddenly acquired Crosby, Ovechkin, Halak (after last nights game), Doughty, and a whole slew of other players. Would you make a bet on the leafs then? Just because 90% of the time, you lost money betting on the leafs in the past (if you chose them randomly at the beginning of the year) – certainly doesn’t mean there is a 90% chance they will lose in the coming year.

That’s skewing statistics in your favor.

My point is that if you plan to take a 5-year FRM, then you MUST plan and understand it. There are certainly signs (and I mentioned a few) which help with prediction. The real problem is that people don’t think about it and blindly sign on for 5-year FRMs. But your advice amounts almost to blindly following 1-year and VRM mortgages even if the odds are against that strategy at this particular time.

Good point. I understand that the chance of it working appears different at different times. However, the odds are always against you.

Remember that the difference between the 5-year & 1-year rates and between the 5-year and variable rates are based on the bond market’s assessment of future rates and the banks’ risk calculations. They always add a safety margin, since the fixed mortgage is at their risk. So, they would all have to miscalculate by quite a bit or things would have to change quite a bit.

You probably have your opinion on where rates will go over the next several years, but the bond market probably has a much more informed assessment.

That is why the the odds are always against you.

This is also why the odd times that 5-year fixed did work were usually times that they were not expected to. When rates are declining, then the 5-year rate may be closer to the short/variable rates, so then if there is an unexpected economic event, it is more likely to be enough.

My question, though, is why would you want to consider this? If it appears that the prospects for the different mortgages would be close, then why would you lock yourself in? You give up your flexibility and negotiating power for 5 years and risk a potential HUGE penalty – and you get almost nothing for it.

You mentioned that variable mortgages are higher risk because of the higher variability in the ending balance after 5 years. When you include the risk that something will change and you will end up paying the penalty, I’m not sure that is true.

Our experience is that a large percentage of people that take a 5-year fixed end up paying the penalty before the 5 years are up. When you add that to the calculation, the uncertainty about your final cost is probably higher with the fixed!

The reason for this is that, in the unlikely event that the variable ends up costing more, it is unlikely to be significant. But if something changes in your life and you pay the penalty, the amount could be HUGE!

If 10 people pay a couple hundred more with a variable, but then 3 pay $10,000 or more in penalties, the overall variability/risk is higher with the fixed. Both the variability and size of the risk is higher with the fixed.

People dismiss the penalty risk, but we have seen so many people that took a 5-year fixed but ended up moving in less than 5 years. Or they lost their job or ran up some debt and need to refinance.

Often, the prospects on interest rates change, so that 3 years into the mortgage, then can end up saving a lot of money by taking a lower rate that is available at that time.

The other issue in assessing risk is that you need to compare 5-year fixed to a combination of the best of all other choices made every year.

Today, we think the best deal is a 1-year fixed. At the end of the year, the best deal may be an open variable. You can ride that through the term or until there is another good rate on a 1-year again.

In short, if the risk of losing money with a 5-year fixed appeared low, we would likely still not consider them. It would take a person super-risk averse, where we are virtually positive that nothing significant will change in their life or their finances for at least 5 years.

This short/variable combination strategy has an even higher chance of beating the 5-year fixed. This combination strategy is what we recommend.

I have been in a VRM for all my mortgages but now I am going to flip to a 5 year fixed because I strongly believe that this is the one time that it will pay off. I have my rate locked in at 3.75% so we will see. Everyone that I have talked to in the industry have a feeling that rates will be rising a lot faster than what people are believing. This is a pure gut feeling but at 3.75% it won’t cost much if I am wrong but the potential if I am right could be substantial. You almost have to look at it like poker. On every hand you have to value every move you are going to make. If there is little value in the move you are better off not doing it.

I might end up being wrong, but I can guarantee you once the 5 year is up I will be back in a VRM as we will should be back at a more “normal” interest rate level.

Ed, very nice rebuttle. I think the basis of why you are such a staunch supporter of this strategy is because you are dealing with many clients and prescribing a best case for all clients in general.

What most people have been arguing is that on a case by case analysis, there WILL be people that benefit from the 5-year fixed. And remember, benefit does not always equate to lower principle balance at the end of the term.

I think it is more important for mortgagees to understand the odds, and not simply follow set strategy. You describe how the bond market can foreshadow interest rate movements. It is not out of the question to expect lay-people to try and understand this – most don’t attempt to, but if they did, it would make the decision between VRM vs. 5-year FRM simpler.

These are the data or facts people should be focused on, and not historical trends or statistics. Just like any strategy in personal finance, planning and projections are key, as long as the goal is achievable, to me it doesn’t matter if it cost me more $$$ to get there if I could be certain I attained it.

what is going to happen to the real estate market after all those rushing into the market to qualify under the old cmhc rules and with a 3.79% 5 year fixed rate are gone. this situation has caused a temporary shortage inflating property values. when these people are finished buying and fixed rates jump by 2% or more the opposite will occur. if you couple that with the boc actually moving in front of the fed driving up the dollar it would be a disaster particularly in ontario and quebec as more manufacturing jobs disappear. one would have to wonder if government institutions are trying to legislate a real estate bubble. call me paranoid but this has happened before

Paul,
I do agree that now probably has the highest probability that a FRM will beat a VRM. Since you have had VRM all throughout the past, you probably have benefited more than if you had a fixed.
And since now interest rates are guaranteed to rise (but how much?) even if the fixed that you locked into, 3.75%, doesn’t win – you will still have saved much over the long run.
Good call in my opinion, choosing now to test out the fixed rate.

As for actually getting a mortgage; I am still unsure wether to invest all my money in RE and have the need to apply for a mortgage and have more liquid assets, or to invest my money elsewhere where my money would be locked up a lot more to guarantee higher ROR.

2010 will definitely be a busy year though, thats for sure, for everyone that watches their money.

I am choosing between a fixed rate at 3.4 x 5 yrs and a variable closed at 1.75 for five. Since I am buying out my previous mortgage at about $12k, I will make my ird back in year 3. Unfortunately, I can’t wait until the variable goes down to -.8 at this time as my ird will increase because of lower posted rates. I am leaning to the 3.4, although my mortgage broker is advocating -.5 variable for 3 yrs, and suggested I may want to lock in at that time, depending. Thoughts?

“Everyone that I have talked to in the industry have a feeling that rates will be rising a lot faster than what people are believing.” Why would you think that is unusual or reliable? Remember that the industry is focused and compensated for locking people in.

I wouldn’t suggest you do this by gut feel either. That is what tends to cause most financial mistakes.

Better is to do the math on how high rates would have to average in the final 3 or 4 years to be even, similar to post #45.

For comparison purposes, the combination 1-year fixed or variable strategy has averaged between 4-4.5% this last decade, so that is what we would consider an average rate. That is the problem that we have with a rate like 3.75%. Here we have historically low rates, but the 5-year fixed rate is only slightly below average rates.

I’ve been trying to create some balance. Of course I’ve been arguing about people and situations in general and there are specific situations for specific people where 5-year fixed may make sense.

Here are our issues:

1. We think that the the correct percentage of mortgages that should be 5-year fixed is somewhere between 0-10%, not the 70% that are taking them.
2. NOT taking a 5-year fixed is almost always the right decision for those that choose it, but taking it is the wrong decision for probably 90% of the people that take it.
3. The mortgage industry seems very focused on locking people in long term. I can’t tell you the last time I met someone that had been recommended to take a 1-year fixed or an open mortgage.

So, I hope this article can help slightly reduce the massive over-use of 5-year fixed.

Let me add some general guidelines from our viewpoint:

People that should not even consider a 4-year fixed include:
1. Anyone that is not sure they will be in their existing home for at least 5 years. “Blend & extend” is a disaster and “porting” your mortgage takes away all your negotiating power. The rule of thumb is: “Never take a closed term longer than you expect to be in your current home.”
2. People trying to pay down their mortgage very fast. A 15-20% annual limit for extra payments is nothing. With a 1-year or open mortgage, you can pay down 100% every year.
3. People for whom saving money is important.

People that should virtually never take a 5-year fixed include:
1. People with uncertain situations, unstable jobs, uneven incomes, that expect that may need to refinance other debts, or that could have large extra costs should focus on the flexibility of open or short mortgages. These are the people most likely to end up paying a HUGE penalty. These are the people most often wrongly advised to lock in to get some “certainty”. When your situation is unstable, why would you lock yourself in and sign up for a potential HUGE penalty?
2. People that are frugal.

Thanks for the support. Your forecast is one of many possible ones, though.

I don’t think the government is trying to create a real estate bubble. I think they are trying to avoid one with the new rules making mortgages harder to get. They are especially trying to make it more difficult for those trying to buy the maximum possible home they can afford or those buying rental properties.

We think the most likely scenario is just a return to normal rates with prime between 4-5%. They might briefly bounce too high before settling at a normal rate.

There has been a long term downward trend in rates since the early 80s cause by aging Baby Boomers, technology, globalization and free trade – all of which are likely to continue once the economy normalizes.

Of course there are many other scenarios, but we think that is the most likely one.

Hi boys. I’ve been reading most of your comments but am still looking for some advice. I am in a BMO Readiline (Line of credit mortgage at prime plus 1%). I’m into it for $180,000 and nervous of the interest payments as prime climbs. I pay interest only on the first of the month and an additional $200 every two weeks. Should I stay or should I go (isn’t that a song?) and if I should go, where to, 1 year, 3 year fixed (in about 3 years my husband will start working again)? I got 3.55% 5 year fixed for my rental property which I was quite happy about. Now I just got to figure out what to do with my residential mortgage. Appreciate any help here.

Do you see the humour in paying a $12K penalty and then deciding which way to lock yourself in next??? :)

It sounds like you are deciding: “Should I lock in now or lock in later?” Why lock in at all? Especially after the last time?

Why can’t you wait until deeper discounts of prime -.8% or more are available? That will likely only happen when rates rise somewhat, so your IRD would be smaller – not larger.

Is there a reason that you wouldn’t take the 1-year fixed we’ve been recommending? Is that not suitable in your situation for some reason?

In general, we are recommending a combination of 1-year fixed or variable whichever is best each year. Right now, we think 1-year fixed is the best option.

We would need to know more about your situation, finances and goals to advise you more specifically. You can email “Ed’s Mortgage Referral Service” with your answers to the 10 questions if that would be helpful for you.

You assumed I was talking to people in the mortgage industry and not in the financial industry. These are people that actually have insight into what the market is expecting, not to what mortage brokers are expecting/wanting it to do. You just said in post #123 you expect the rates to be between 4-5 with a brief bounce above 5 and then settling back down.

In my original chart I posted I only had it hitting 5%, if you are expecting a bounce above then that would trend more in the favour of a 5 year term. So for the chance of saving a few hundred dollars is it really worth the risk of a large bounce?

You also can’t just use the last decade as the average, as this has been one of the most bizarre decades ever. It would be more interesting to look at the last 20 years to see what an average might hold.

For all of those who are strongly in support of locking in a 5 year mortgage with fixed interest rate because of the inevitable rise in prime, how many of you have locked in your natural gas contracts with the inevitable rise in NG from historical lows? Or taken the sweet deal of a 3 year subscription to your favourite magazine that locks in the current annual rate rather than risk the rise?

Is the larger exposure to your cash flow that distorts your logic or are you consistent? The psychology of money is extremely strong and can lead people to make irrational choices – either too conservative or too aggressive.

You’re right. I was assuming it was the mortgage industry, not the financial industry. That would be more reliable.

We have been hearing a variety of differing forecasts, though. On the internet, people seem convinced of high inflation and rates rising quickly, but various financial people, fund managers, etc. are split. If anything, they think that the hype is overdone.

Anyway, IF the forecast is close, my question would be the opposite of yours. For the chance of saving a few hundred dollars, why would you want to RISK locking in for 5 years and be give up all your negotiating power and flexibility???

In our experience, at least half of people that take the 5-year fixed end up paying the penalty at some point. I have never found any stats on this, but I’m sure it is a lot higher than most people think.

We would see locking in as a big risk – perhaps a 50% chance of having to pay a $3-30,000 penalty.

Give me a break; Cannon’s comments are not insightful at all. Consistent logic is not always linear or scalar. What is logical for small dollar amounts may not be logical for large dollar amounts. Do you hire a “coffee inspector” to examine every cup of coffee you buy just as you hire a home inspector when you buy a home? Or is it “the larger exposure to your cash flow that distorts your logic”?

The whole point of locking-in mortgages is to pay insurance so that you don’t lose your shirt. If you can’t afford a magazine price increase, you have bigger problems that choosing a VRM or FRM.

I’ll note that Moshe Milevsky just came out again yesterday cautioning buyers and noting that there is almost certainly a huge drop in home values coming. Despite what Ed says, negative equity is not something you want to risk.

In our experience, at least half of people that take the 5-year fixed end up paying the penalty at some point. I have never found any stats on this, but I’m sure it is a lot higher than most people think.

Baloney. There is no way it is anywhere near 50%. If you are going to make this claim, you had better find some stats to back it up.

There is a whole lot of baloney after reading some of Ed’s comments on this article…

” People with uncertain situations, unstable jobs, uneven incomes, that expect that may need to refinance other debts, or that could have large extra costs should focus on the flexibility of open or short mortgages. These are the people most likely to end up paying a HUGE penalty”

I believe you can add-on to any mortgage that you get through the banks so I am not sure why they would ever have to pay penalties to add-on to debt. Also would these people with high debt more than likely be chasing the lowest payment in a VRM anyway….

“Let me be clear, though. We are recommending 1-year fixed today”

Why would you recommend a 1 year fixed today knowing that any term your client chooses a year from now is going to drastically higher than rates today. I think If you were my financial advisor and I came back to you a year from now and 1 year rates were 2% higher and prime was 2% higher…even with a lower discount (maybe). I would fire you!!!

“Take whichever is better between 1-year fixed or variable because it will almost definitely save them money. Plus maintaining flexibility and negotiating power can save a lot more money.”

I can see the flexibility with VRM…. to be paid out with no penalty, if you win the lotto!! But how many people take advantage of the many prepayment options on VRM or FRM for that matter. And how in the world does a VRM give you more negotiating power. If you hold a VR mortgage with a bank they still have you by the short and curlies becuase the know that if you threaten to move it, you will have additional costs, appraisals, transfer out cost, legal fee,plus your time to go and apply with another bank/broker.

Don’t get me wrong I have held a VRM for a number of years. I locked mine in two months ago at 3.85% for 5 years. Sorry Ed, there is no way in hell taking 5 – 1 year terms or if I would have renewed to a 5 year closed that I would save as much money as I will by locking my mortgage in for a fixed rate for 5 years. And I have the security of knowing my rate will not change. You can’t put a price tag on that. It doesn’t take a rocket scientist to know that rates have increased by over a percent already in the past month and prime hasn’t even moved yet.

I think you are giving the general reader really bad advice, by making general statement like you have. It is unproffesional first and foremost, but also you are not considering the risk clients have, by going short term or the fact that their
interest cost in a variable mortgage will increase over the next 2 years for sure. Not once have you stated that there would be any difference in your advice, based on the equity your clients have in their homes. Could all clients handle at 2% increase in prime plus a 10 percent drop in the value of their home. I for one believe there are time for variable rate mortgages and times for fixed rate long term mortgages. Now is the time for the ladder.

The difference with our experience is that we actually do the calculation for clients to see whether it is worth it to pay the penalty to get out of a 5-year fixed. Most people don’t really look at their mortgage during the term.

In the last decade, most of the people we meet that have had more than 2 years left in a 5-year fixed mortgage could save a lot of money by paying the penalty to get out.

This came in waves. When rates were flat or declining, the benefit was usually obvious and large. When rates jumped up, then often there was no benefit.

We did not keep stats, but I would estimate that about 80% of people with more than 2 years left during the last decade benefited by paying the penalty to get out and take a variable or 1-year mortgage. (This included a few people that benefited by paying a $5,000 penalty 2 months after signing up for a 5-year fixed.)

For people with less than 2 years left it would have been quite a bit less than half, so let’s say about 30%.

We have never seen official stats, and I’m sure they would be quite a bit lower, since most people don’t even look at it. But we believe that if people with a 5-year fixed calculated regularly whether they would expect to save money by paying the penalty to get out, my guess would be that at least 80-90% would benefit at least once during the term.

For people considering taking a 5-year fixed, we would suggest to assume in your calculations that there is a good chance that you will end up paying the penalty before the 5 years are up.

I just may be in the situation where the 5-yr fixed makes sense. I’ve only ever held variable, and strongly believe that is the way to go. However, based on current interest rate forecasts (the big banks provide this until the end of 2011, my assumption is that the trend upwards will continue), I am leaning towards a 5-yr fixed. My situation is unique because I have a 120 day rate hold with ING at 3.89% that expires in June. Today’s variable rate is 1.75% (prime – 0.5%). What would you recommend in this situation (Ed and others)?

Ok Ed… I will bite… I wanna know how you can possibly explain to me how paying a penalty is in my best interest. Also please give me your recommondations on what term I should be going into. My current rate is 5.19 this included a discount of 1.40 when I took out my 5 year term. I have 27 monthes remaining. the following term market rates will apply for you to calculate my penalty 1yr 3.80 2yr 4.15 3yr 4.75. Penalty as you know is the greater of 3 months interest or IRD.

Check out the BoC Overnight Target Rate estimates for end of year 2011. They are predicting rates of 3.00%. So if you are at a VRM then you will be paying anywhere from 4.15% to 5.00% depending on what type of discount you can get from your bank.

Obviously these are just estimates but it is something that you need to think about. If they revamp the world monetary policies to how Canada would like to see them, then we would see a change in what we used to see as normal interest rates.

I can already tell you what Ed’s advice is going to be… take a 1 year FRM… but if you read all the posts there seems to be a repeated message… a lot of people believe that Variable Rate Mortgages are usually the way to go (myself included) but when my mortgage needed to be renewed in January and I was offered a 5 year FRM at 3.65% I took it… and again as other people have mentioned if I’m wrong by taking the 5 year FRM it won’t cost me much but if I’m right… it could save me quite a bit of $$$$$$$$$$

Thanks for your thoughts Ed, I guess I see the humour, although I do find the 3.4 rate hard to resist. In the meantime, I have found a prime -.7 rate and will stick with that for the time being. I am in a bit of a hurry as I am undertaking some renovations. Time will tell indeed. This is a great fora and I have found it useful in my discussions with my financial planner.

The 3.4 fixed for 5, I got in March before the rates took a hike (holds for 120 days). At that time, -0.4 was the best VRM I could find. While I was doing my research on MDJ, I googled something like “mortgages prime -.7” just to see what came up. I looked it up, checked it out and am now in the -0.7. I also checked out ratebot.ca and it had more details as well, again SMP was the lowest.

Your penalty will be worth paying, but i would suggest to either take the 1-year fixed now or you could just wait until you can get a variable at prime -.8% or more. The discounts on variable are increasing, so it could be only a few months before that is available.

I would not recommend the variable prime -.5% you are thinking of (savings of .8%), since it seems that deeper, normal discounts are probably not far away.

The IRD calculation is done different ways by different banks. First you should call you bank and find out what the penalty will be. It is always best to know the actual number, and not make a decision just on a calculation.

We just had another one at 5.19% with a larger mortgage. The penalty was $16,000 with 3 years left. With such a large penalty, it is borderline whether or not it is worth it. They may be stuck for 3 more years.

In that case, we know what this year’s rate would be. The rates would have to average 3.69% or less for the 2 following years to make back the $16,000 penalty.

If their prediction of an increase of 2.75% by the end of next year comes true, then prime rate would probably rise from 2.25% to about 5%. If the variable discount of prime -.85% returns as well, then the mortgage would be 4.15%.

That is quite typical of the rates in the last decade. They have varied, but that has been close to the average.

That may well make sense. If their forecast happens, then someone took a 1-year fixed today at 2.35% should be able to get a variable at 3.65% next year and then 4.15% for the following year. If there are no declines after that and rates stay 2.75% higher than today, then the average mortgage rate for the next 5 years would be 3.69%.

There has been a long term downward trend since the early 80s. If that continues, the average of the next decade could be a bit lower than the last. That could also mean the average rate for a combination of 1-year fixed and variable would average a bit lower than 3.69% for the next 5 years.

Of course, this is just an estimate and actual rates could be higher or lower than that.

It is usually not best to rush these decisions. Prime -.7% is a pretty good rate, but with the deeper discounts appearing to be coming back relatively quickly, you may be disappointed having the smaller discount for 5 years.

We would suggest to try taking an open variable or 1-year just to buy some time until you can get prime -.85%.

I’m feeling a bit lonely here. I’ve noticed that almost every post here has been someone claiming they are the one unique exception so that a 5-year fixed could possibly work.

Does NOBODY agree with me???

Does anybody think like me – that variable or 1-year fixed is nearly always the smartest strategy, and today the best choice is probably the 1-year fixed (until we can get deeper discounts on the variable)?

I agree with you Ed! been reading it all with great interest. We just bought our first house and will be taking a one year fixed at 2.25% (wonder if we can do better?) at TD. We bought a house that is well within our means and will be paying the mortgage back as if we have a fixed rate of 4%. We were also offered a 3 year fixed at 3.4%. (I also have a 3.8% rate hold at PC).

In the end I decided to hold onto the one year fixed, although the three year is a decent option. (We close June 24th.) Interestingly, our mortgage broker at TD talked us into the one year or three year, her reasoning: if you’re leaning towards variable take the one year and wait for better discounts and if you’re leaning towards fixed, take the three year – but a five year rate is much too long to be locked in. When I asked her what her mortgage is, she admitted variable (always an interesting question for your mortgage broker!).

I’m a big believer in variable/one year rates, my husband would rather do a five year fixed…part of me thinks we should split the mortgage 50% variable, 50% five year fixed to avoid any possible fights. But the thought of paying more interest than necessary makes me really annoyed! We could also handle substantial rate increases in the unlikely chance they really go up.

Thanks for all the discussion, very much enjoyed it Ed! Definitely helped us make our choice (a lot of it has been forwarded on to my husband.)

Ed, I’m a discounted open variable mortgage guy myself, but since they aren’t readily available in this market, the options are fairly limited. I think that a lot of people veer away from 1 yr fixed mortgages is because they wont’ want to negotiate once a year even if it’s to their advantage. A lot of people simply want to get a good rate, and pay that rate for x number of years.

Ed… My penalty is 7800. The penalty is based on my current rate and my current discount as well as the closest rate to the term I have remaining. In this case it is two years. So the penalty is based on 5.19 – (4.15-1.40) = 2.75 127000 * .0275 / 12 * 27 = 7858. Now am not sure what you said to your other client whose rate was 5.19. I am no expert but it appears my penalty is 2.75% on my entire mortgae for 27 months. If todays one year term rate is 3.40. I am paying. 5.19 – 3.40 = 1.79% less for 27 months. But I had to pay 2.75 per month in order to get the lower rate. As well I don’t know what the one year rate will be next year. I could also do a open variable at 2.25 ( 5.19 – 2.25 = 2.94) This option would save me money (2.94-2.75= .19% per month) But we all know prime is going up. Some say up to 2.50 – 3.00 within the next 18 months. Even waiting for a bigger discount on prime doesn’t do much good becuase you are just getting a bigger discount on a higher prime lending rate. If you could please email me your calculations on how you think its beneficial to pay penalty. Thanks

Thanks always for your thoughts. What additional costs are incurred with each (yearly) renegotiation. For condos, for instance, the ones that I can think of off the top – status certificate $100, appraisal(2-300?), legal for new mortgage ($700), legal for discharge from previous bank/fin inst ($275-400). How does that factor with the negotiations every year? Doesn’t that eat up a couple of pts? Just curious.

Again, you still have not addressed the negative equity issue with 1-year fixed mortgages.

Currently, prices are high. Virtually all economists are predicting higher rates and a drop in housing values. Some have even suggested a dramatic drop in house values.

With a one-year fixed you had better have enough equity when you buy to prevent yourself from going into negative equity after home prices drop. Otherwise, you will not have access to the deeply discounted Variable Rates when your mortgage comes due. And, if you still don’t have 20%, you will have to start paying CHMC insurance. This can all add up to a lot of money.

And, sorry Ed, but I simply do not believe you that Banks will not ask you for an assessment at each renewal. The BMO mortgage fraud case is just another reason why such assessments have become standard operating procedure — even on renewals.

I’m also still waiting to hear who these lenders are that will let your VRM payments stay fixed, even if it results in your payment not covering the interest. Link?

It’s good you didn’t split the mortgage. Splitting the mortgage is another trap used to lock you in. Having half in a 5-year fixed is the same trap as having it all in a 1-year fixed.

If you go half 1-year and half 5-year, then you still lose your flexibility and negotiating power. When the 1-year comes due, the bank knows you are stuck with them. You can’t move anywhere else without paying the penalty on the other part. you may well find that the bank doesn’t even offer you much of a discount.

I agree. Many people take the 5-year fixed just to avoid the hassle of renegotiating, even though it can be hugely profitable. I can’t imagine that people would not want to spend an hour if it can save them $2-5,000/year after tax!

Fees are a factor, but usually a small one – and only usually if you are moving to a new bank. Most of our contacts actually pay part or all legal fees. Some also pay for appraisal fees and others often don’t do appraisals (believe it or not). In most cases, the only costs are the discharge fee and possibly a bit of legal.

When you compare this as a percentage of the mortgage, it’s usually a small percentage. If you pay between $250-500 total on a typical mortgage of $200-250,000, it is between .1-.25%.

Some banks will actually charge you fees if you stay with them, if you want to refinance in some way or reappraise for a large mortgage or credit limit. In these cases, it may cost as much or more to NOT move a mortgage.

Okay, let’s do the math & see whether or not it makes sense for you to break your mortgage. Your penalty is $7,800.

If you keep your mortgage, the interest you will pay to maturity is $127,000*5.19%*2.25 years = $14,830.

Today, we are getting 1-year fixed at 2.35%. After adding the penalty to your mortgage, it will be about $135,000. So, in year 1, your interest is $135,000*2.35%=$3,170.

So, to break even, in the remaining term, you need to interest less than $14,830-7,800 penalty-$3,170=$3,860.

At that point, you have 15 months (1.25 years) left. So, the percent you need to be below is $3,860/1.25=$3,090. Divide $3,090/$135,000=2.3%.

So, what are the odds that you will be able to renew in a year at or below 2.3%? Probably very low. That is a tad lower than today, and we expect rates to rise.

In your case, you are trapped!

It does not really make sense to break your mortgage, unless you have other reasons to refinance, such as rolling in more expensive debt.

Any rate over 5% is quite high, so you would think it would be worth it, but sorry, you have to work this out individually for each person’s situation.

Did you actually call the bank to get your penalty, though? Or did you just calculate it? You need to call to get the actual penalty, because it may differ quite a bit from your calculation.

And don’t believe it if they say it will take them a day or 2 to get the number. It is right there on their computer screen.

Different banks calculate IRD differently. The calculation you showed is one of the most punitive.

5-year rates are normally higher than 2-year rates and you can normally get a larger discount on a 5-year rate. So, comparing your existing rate to today’s 2-year rate minus the discount your received on your 5-year mortgage is quite punitive.

It might help to recalculate again when there are about 19 months left. Then they are still comparing to the 2-year rate, but the IRD is calculated over a shorter time period.

Anyway, in your case, Kelidon, if your penalty number is correct – you are trapped!

All I can tell you is that we had clients in 2006 where the rates had risen and the payment on their variable mortgage did not even cover the interest, but the bank just left their payments the same.

The banks also still mail out a form for a straight renewal, so people could just sign it and renew, without a credit check, appraisal or anything. Nobody should ever do that, since the renewal letters are the posted rate. We have had no trouble getting a renewal at the lowest rate for people that lost their job during the year, and the bank to my knowledge has never asked about the home value on a straight renewal.

I called a couple bank contacts to ask them at what specific point they might increase a payment if the mortgage balance keeps going up and have been waiting to hear back, so I could quote the exact rule. This kind of info does not seem to be on their web sites.

As a mortgage broker, have you done straight renewals, Bob? Unfortunately hardly anybody compensates mortgage brokers for servicing existing clients on a straight renewal, unless they refinance or move their mortgage.

All I can tell you is that none of these things have ever been an issue for us, Bob.

For the fourth (fifth?) time I’ll ask: WHICH LENDERS are you talking about? Because this is NOT standard practice in 2010 as far as I can tell. To get discounted (and even posted rates) now, appraisals are required. And people with average incomes who are underwater on their mortgage don’t get offered the best rates. Period. Unless you can tell us specifically who operates differently . . .

Why are you so reticent to tell anyone exactly which lenders you are talking about? Is it because you are getting special treatment that isn’t available to regular consumers? If so, you need to tell us this, because you present your advice as if it is applicable to everyone, not just your own clients. If your advice is only applicable to “special deals” that only you can get, then it is misleading to pretend that it should be applicable to everyone.

As I stated above, I am not a mortgage broker. I’m a mortgage consumer, so implications that I’m simply interested in the topic as a means to line my pocket are way off the mark.

I’m interested simply because I don’t think you are presenting both sides of the coin fairly.

I am not sure what “banks” you are dealing with, but I can tell you for a fact that your comments in regard to renewal documents being printed with posted rates is absolutely incorrect. You continue to make general statements leading the readers of this article to believe that you are an expert when it comes to the neogiation practices of banks and brokers in general. Statements such as the one above along with others such as access to credit and negotiating power being better by being in a variable rate mortgage are misleading and have no truth to them. You have also reccomended to one client who had a interest rate of 5.19 to break there penalty yet another poster wtih the same interest and I would assume a very similiar term remaining, it was not worth it to break. Plus no mention of the interest cost over 25-30-35 years for people who add penalties onto the mortgage. This is simply bad advise.

There is not one person who has an interest rate higher than todays current posted rates that would not love to have a lower rate. The fact of the matter is, there is no-one that can predict for certainty what rates will do 1/3/5 years out. The reality you fail to see in your standard advise to all clients is, that everyone loves the low rates when prime is low / 1 year fixed is low. They state that they understand the risk…. yes risk… asscociated with being in a short term mortgage. It isn’t until the next year comes, and prime has increase by 2% 1 year fixed increased by 2% that people truly understand what their appetite for risk is. I am not sure how many clients you have the opportunity to sit with after setting them up in variable rate mortgages when it comes time to renew and they find out their amortizations have skyrocketed due to increasing prime lending rates. I can tell you for a fact, being in the business for 15 years that client have a much different attitude when rates have gone up or equity markets have gone down. When you remind them of conversation you have had in the past, their memories become very selective on what the remember or do not remember.

Your posts are becoming commical to say the least. I have stated in the past that your advice is “cooker cutter”. You believe that all clients can accept the same amount of risk… yes risk… when choosing terms for mortgages. I would really love to hear what you recommend to clients in regard to retirement portfolios. Does a 20 year old and a 60 year old have the same portfolio? Is it best to go with 100% equties, since over the long term they will outperform bonds. This is the basis of you argument with variable rate mortgages. I don’t believe anyone has disputed that fact that over the long term Variable will provide a great amount of interest saving vs a 5 year fixed. So please let all your readers know. Is you advice in regard to investments such as stocks, bonds, mutual funds, GIC the same garbage you spew about mortgages. I really don’t expect an answer to this question or the one that Bob has asked mutiple time. Becuase to be very honest I don’t believe you have one that fits with the advise you give.

Sorry, I thought you were a mortgage broker. You sound like you are speaking from experience.

We have a variety of mortgage contacts, but the vast majority of our mortgage referrals have gone to the banks, such as TD, BMO or Royal. My hesitance to name them in response to your questions is because I don’t actually know all the answers for each bank – and neither do our mortgage contacts. Specifically for your question about what happens if rates rise so much that they don’t even cover the interest, our bank contacts are telling me this has never come up. They have had to talk to people at head office to try to find the answer.

For example, our today’s rate of 2.35% with a 25-year amortization and a $100,000 mortgage would be a payment of $441/month. In order for this not to cover the interest, rates would have to rise to 5.35%. Rates would have to more than double.

BMO was our main source of variable rates (before they eliminated their excellent 3-year open variable in an SM mortgage). Our BMO contact has been in the industry for more than 20 years and has never come across this issue. I have heard now (but not confirmed) that BMO will increase your payment if the mortgage principal reaches 105% of the original mortgage.

For this to happen, rates would have to rise to more than 5.35% and stay there for quite a while. It seems that this has not happened in the last couple decades.

I asked our various contacts, but don’t have answers from most yet. It seems every bank has different rules about this.

You asked about renewals, but those aren’t an issue. BMO & TD have confirmed that they never do appraisals, credit checks or income verification on a straight renewal. You are free to negotiate whatever term you want, as long as it is a straight renewal.

Getting the best rates is a matter of effective negotiation, which generally can be done on even on a straight renewal.

You asked if we get special treatment not available to the general public. That’s a good question. I don’t think so. I have always thought that it was just the way we negotiate. We do refer a lot of mortgages, know exactly what to ask for, and are very focused on the term that we believe is the smartest at any point in time. I’m pretty sure, though, that anyone with a good credit rating that was good at negotiating mortgages should be able to get a similar rate & terms.

Having a 1-year or variable mortgage clearly gives people more negotiating power and flexibility than a 5-year fixed. With a 1-year, your mortgage comes due every year and you are free to negotiate or refinance any way you want – with no penalty.

If you are in the middle of a term and have a large penalty to break your mortgage, your options are limited. If rates drop and you want to take advantage of the lower rates; if you need to refinance some other debt; if you want to move; or whatever – having a large penalty is a big problem.

You might be able to negotiate a bit with your existing bank or add a second, but your options are limited – and your bank knows your hands are tied!

Even with a 5-year variable closed, penalties are quite often much less than with a 5-year fixed, so the restrictions on your options are reduced.

The 2 clients with existing rates at 5.19% turned out to be quite different situations. They had different number of years until their term came due, different mortgage companies, and more importantly a huge difference in the penalty they would have to pay.

When we calculate whether or not it is beneficial to break a mortgage (we call it “Ed’s Mortgage Breaking Calculation”), it is only the difference between the 2 options during the term that matter. The interest over the next 25 years is not relevant.

For example, if someone has 2 years left in a 5-year fixed and the penalty to get out is $6,000, but best estimates are that they would save $10,000 in interest by taking a new low rate, then breaking the mortgage is probably worth it.

Calculating the interest on the $6,000 penalty over 25 years is not relevant, since they saved more than that during the term. Even with the penalty added to the mortgage, they end up with a lower mortgage balance at the end of the term.

The risk is generally lower with a 5-year variable with fixed payments than with a 5-year fixed. In both cases, you have a constant payment during the 5 years, which is the main concern about risk. At the end of the 5 years, in both cases, you need to renegotiate at that time.

The lower risk effects of the variable are that the penalty to get out is quite probably much less, so the risk of something happening in your life where you would benefit by refinancing is lower. You are less trapped with a 5-year closed variable.

Also, if you choose the same payment, you have a 90% chance of having a lower mortgage balance at the end of the 5 years, so your renewal payment will probably be lower.

The 1-year fixed is not a lower risk option. It is the option that we think will save the most money right now. We think it is the best option for the vast majority of people for whom saving money is the most important issue.

There are other ways of dealing with interest rate risk, as well, other than trapping people for 5 years. Having an emergency fund (savings or available credit line) in case payments rise and education about the savings and risks usually give people the confidence to make the choice that will most likely save them lots of money.

It is probably true that some people might not remember your explanations later when interest rates are higher and may blame you, but we haven’t really had a problem with that. Most of our clients are more interested in saving money. And I guess they realize our advice is not a guarantee of savings and that we are genuinely trying to help them save money.

We also see educating the public and our clients about mortgages and how to save money as a mission. The odds are so strongly against 5-year fixed. If you take 2 in a row, I’m sure the odds of saving money by avoiding the 5-year fixed are 100%. And we think that most of the reasons for taking them are exaggerated fears of unlikely events.

We think that the percent of Canadians that should take a 5-year fixed is somewhere between 0% and 10%, but it seems that about 70% are taking them. We think the reason they take them are lack of education.

It is easier to let people take the 5-year fixed that most ask for, but we think that the right thing to do is to spend the time to educate people, quantify the potential savings and the risks, and then give them a recommendation that fits their situation, so that they can make an educated choice.

For us to recommend a 5-year fixed, we would need to expect to save a significant amount to compensate for being trapped.

Of course this choice varies by client, but if the goal is to save money, then for most clients, there is a benefit of having the flexibility and negotiating power.

To put a number on it for a typical client, we would want to be at least .5%/year lower than the average interest rate we would expect over the next 5 years from using the combination 1-year/variable strategy.

Since our best guess is that the average of the next 5 years by taking whatever is best between 1-year and variable would average between 3.5-4% (taking into account that we can get 2.35% for year 1), we would probably want to be at least .5% lower than that before we would start seriously considering a 5-year fixed.

Tster The last time i received an offer to renew from my bank it was the ridiculously high posted rates that were offered. This was 6 years ago, maybe the banks have terminated this practice. Have to wonder how many unsuspecting people were victims.Every post from Ed has been 100% correct,it has to be its math.If you want the security of a fixed there is a premium to be payed. with me its a risk reward thing and i plan to convert to a fixed shortly as i no longer have appetite for the risk. Tster sounds to me like your a loyal bank employee,if so your going to hate my closing comments. All to often in dealing with bank “specialist” i have found the individual to be less knowledgeable than myself.This applies to investments as well as mortgages. perhaps if my net worth was higher id get the guy with the masters degree. This has never been the case with my broker. My advise to all.Find a reputable broker, take his best rates to your bank and if they offer to match say no thanks ill go with my broker.that and by etfs not mutual funds

My hesitance to name them in response to your questions is because I don’t actually know all the answers for each bank – and neither do our mortgage contacts. Specifically for your question about what happens if rates rise so much that they don’t even cover the interest, our bank contacts are telling me this has never come up. They have had to talk to people at head office to try to find the answer.

Frankly, I find this very difficult to believe. All of the information is available on the Banks’ Mortgage websites.

This, for example, is from TD’s website:“Should interest rates rise, more is applied toward interest. If interest rates increase so that the monthly payment does not cover the interest costs, you have the option of adjusting your payments, making a lump-sum payment or paying off the balance of the mortgage.”

Here is from National Bank’s website“Fixed payment: this option facilitates budget planning and allows for a larger payment on principal. The fixed payment amount may be revised if it no longer covers current interest expenses.”

Thanks for your comments. I do work for a bank, and I understand that their are both good “specialist” and bad that work for all FI. This comment must apply to brokers as well! You can’t really believe that all Mortgage “specialists” that work for a bank are bad and all brokers are good do you? If you are looking for a reputable broker, is not possible to find such a person that works for a bank. Am I a loyal banker? I will glad say yes. I don’t believe in everything my bank and other do but I am not sure if any employee can truly say they support their employer 100%.

It is articles such as these that bring readers out and encourage them to “bash the banks”. Comments that refer to huge profits, making money on service charges and Ed’s comment that bankers “push” 5 year fixed to make their banks more money are absolutely not the case. As a Canadian would you rather deal with a US bank which is losing money? How safe to you feel depositing your paycheck? Do you drive through Tim Hortons and rip a strip of the young lady that is handing you your coffee becuase their profit was up 25%?

You speak of how many “victims” there have been with clients that sign mortgage renewal documents without negotiating better rates. I take exception to comments like these. Who’s job is to ensure client read their mail? Does the bank need to phone every client to remind them of something which should be common sense? Whether I work for a bank or not, I think it is common sense to read my mail and if I don’t, I only have myself to blame. Is it Safeways job to ask every client if they clipped a coupon for 75 cents off their cheese purchase?

Ed’s comments are not all correct. He speaks as an expert to banks and broker which he is not. I will give one example from many I have read. Ed states you gain negotiating power with shorter terms mortgages. “You can change any term you want, get a free appraisal, negotiate a lower rate, or get an unsecured credit line or other banking service.” This is so far from the truth. In Canadian banks you must QUALIFY for credit… it isn’t handed out becuase you took a 1yr term over a 5 year term. Appraisal fees are negotiated based on the strength of a client not which term he/she selects. Why would ED make a comment like this and lead every single person who reads this article to believe that if you choose a variable or 1 yr term you can get a free appraisal!!! Absolute garbage, plain and simple

I like your investment strategy… I do have mutual funds and have done quite well on them just about a 20% annual return over the past 15 years… And thats a mutual fund (sector fund). I am sure you would agree though, that just becuase I can handle the fluctuations of what this fund can do, doesn’t necessarily mean my 20 year nehpew could or my 70 year old father!!! Once again Ed believes ALL clients should be in in 1 year fixed or variable. I guess this makes for easy advise.

There’s an argument to be made for holding a small portion of your mortgage on a HELOC and using your regular cashflow to largely eliminate the interest charges (pay down HELOC with your paycheques, pay expenses out of HELOC as they come due). I haven’t really played with the numbers enough to see how worthwhile that would be.

This is the type off approach used by mortgage acceleration programs. Using this approach you can pay off your mortgage in half the time and save a ton off money. It does require fiscal discipline but not extra payments per se. I tried to link to a site describing the SmartEquity program earlier but was not allowed. If you want more info send me an email and I can give you the link. Here is an article that describes these types of strategies http://activerain.com/blogsview/600420/mortgage-acceleration-programs-explained

I don’t think those quotes from the bank web sites are what you think. TD sends a letter to clients with every interest rate increase asking whether you want to increase your payment to keep the amortization the same. This is your option – not a requirement from the bank.

I don’t think that ALL clients should take 1-year fixed, since saving money is not the most important thing for all clients. However, I do question mortgage reps when most of their customers are in 5-year fixed.

They are more profitable for banks because of higher interest and less cost of doing renewals, and bankers on bonus programs or mortgage brokers on commission, they usually pay better.

I don’t know exact numbers, but we have heard figures of roughly 70% of Canadians being in 5-year fixed mortgages. I would suggest that the majority of these people received bad advice.

We are often approached by mortgage people wanting to be our source. We only want to work with people that we believe genuinely have their clients best interest at heart and that will follow our recommendations.

One of the simple tests we use is that we don’t work with mortgage people that have most of their clients in 5-year fixed.

I’m not bashing banks in general. Our Canadian banking system is quite good. But people should realize that when they are negotiating with a bank, they are negotiating AGAINST the bank. The higher rate you take (generally), the more money the bank makes.

What I meant to say in my previous post is that you can CHOOSE whatever term you want on renewal. If you are trapped in the middle of a 5-year term, you are not really in a good position to negotiate, since the bank knows you would have to pay a penalty to refinance or leave.

But when your term comes due, you are in a much stronger position to try to negotiate. We have seen people negotiate lots of goodies when their term comes due – lower rates, your choice of term, free appraisals, unsecured credit lines, occasionally bank fee reductions etc. are possible things you can try to negotiate for that we have seen people get. Of course you need to qualify and some banks are much less likely to offer any of these goodies, but we have been able to negotiate most of these relatively routinely for our clients.

This is why you have so much more negotiating power and flexibility with a 1-year or open mortgage. Every year, you can try to negotiate for the best deal and possibly some extra goodies. With some experience, this can be fun and profitable.

The mortgage industry is quite competitive, so if you don’t have a penalty to pay, you are free to negotiate with any bank and can easily move to whichever one gives you the best offer.

Mortgage acceleration programs don’t really work, except possibly if your income comes in huge lump sums during the year or if you are the type that keeps $50,000 in your bank accounts.

Perhaps you are referring to something else, but the ones shown in the article are:

1. Just paying more in each payment to reduce your amortization.
2. Having bi-weekly mortgage payments. This actually only saves you money if you are paid bi-weekly, if you include the cost of carrying dormant cash in your accounts waiting for your next mortgage payment.
3. Using an Australian mortgage. This is like Manulife One. They allow you to essentially always have your bank balances combined with your mortgage, so you owe less. If you do the math, the savings are usually not that high. For example, if my average bank balance is $2,000 and my mortgage interest is at 2.5%, then I only save $50/year by “combining all my inefficient accounts into one”.

In addition, Manulife One has relatively high monthly fees and is generally not at all competitive on the mortgage rate, compared to what you can get by shopping around. The monthly fees and especially the mortgage rate are usually much more significant factors.

I don’t think those quotes from the bank web sites are what you think. TD sends a letter to clients with every interest rate increase asking whether you want to increase your payment to keep the amortization the same. This is your option – not a requirement from the bank.

Ed

Aaaarrrrgghh. I’m done with this conversation because you consistently misrepresent things.

Whether TD asks you whether or not you want to increase your payment to keep your amortization the same when rates change has absolutely nothing to do with what they will do when rates rise so high that your payments do not even cover the interest.

You made several claims in this thread such as (1) your payments in a VRM will stay the same even if they no longer cover the interest and (2) that you were finding it difficult to find out what happens when interest rates rise so high that they no longer cover interest.

The first one is just false, and the second one is suspect given that it is on the bank’s websites.

Contrary to your claim, the TD website says explicitly what happens when your fixed payments no longer cover the interest:

If interest rates increase so that the monthly payment does not cover the interest costs, you have the option of adjusting your payments, making a lump-sum payment or paying off the balance of the mortgage.”

Note that you do not have the option to keep your payment the same. It is very nice that they let you adjust your payments to keep your ammortization the same with “regular” rate rises. But if your payments no longer cover the interest, you have no option to keep your payments the same. Contrary to what you say, this is a requirement of the bank.

The new mortgage rules for qualifying for a mortgage support the 5-year variable as the safe choice, instead of the 5-year fixed.

Even though you can get a variable at 1.75% today, you must qualify based on the posted 5-year fixed rate of 6% or more. This should mean that if rates rise by 4.25%, the variable would only rise to 6%, which is a rate you should be able to afford – since you already qualified for the mortgage based on that rate.

So, there are 2 types of risk:
1. Mortgage rates rise making your payment rise.
2. Something happens that causes you to want to refinance.

The 1st risk will now be small, since people have to qualify based on rates more than 4.25% higher than today’s rate.

The 2nd risk is much more significant and one we have seen far more often. Something happens to make you want to refinance – such as you want to buy a car, you ran up some debt at higher rates, you lost your job and need to borrow based on only your spouse’s income, you want to move, etc.

In any of these cases, having a potentially HUGE penalty may make refinancing impossible.

People seem constantly worried about “what happens if rates rise and my payment is increased?” We have not actually seen this happen.

But what about the worry of “my spouse lost her job and we need to refinance our credit line or car loan so we can still make payments?” We have seen that type of incident happen quite often.

That is, in our opinion, the biggest risk of mortgages for those barely scraping by on their payments. This is why, for most people that are barely scraping by, the 5-year variable with a fixed payment is safer than the more risky 5-year fixed – especially now under the new mortgage rules.

Of course, for probably 90+% of people that are not barely scraping by or have some sort of emergency fund or available credit, saving money on their mortgage is the biggest issue.

Just to be clear, again, we are recommending the 1-year fixed today – not the variable for most people. We see the best mortgage for most people based on their objective as:

1. Save money on your mortgage – Take 1-year fixed (until we get larger discounts on variable).
2. Avoid risk of losing home – Take 5-year variable with a fixed payment, especially an open variable (and keep more options of refinancing).

Note that in both cases, the 5-year fixed is likely not the best choice.

Maybe you are right. I’m not misrepresenting anything – just telling you what our bank contacts are telling us.

We don’t just look at web sites. We talk to the experts. Since we have a mortgage specialist we work with all the time at various banks, why would I try to interpret what it says on their web site?

Our TD contact told me that they always send the letter giving you the option of increasing your payments any time prime rises. She has not yet confirmed your interpretation of the quote you found on their site, but your interpretation sounds right.

Our BMO contact confirmed that they increase the payment “if the loan balance exceeds 105% of the authorized loan amount.”

The mortgage document states:

“If the interest rate increases to an estimated _____% per annum, the Borrower’s first scheduled payment will not cover the interest that has accrued and become payable to the date of the Borrower’s first scheduled payment… As the Borrower’s payments are not adjusted automatically to reflect changes in the interest rate, negative amortization may occur.”

The reference to the first payment is because each payment reduces the principal, so it would take a larger rate increase before the 105% of the approved amount is reached.

We are trying to figure out exactly how high rates would have to go before the bank would increase the payment on a variable mortgage. We can get a variable today at 1.75% (prime -.5%). For a mortgage of $100,000 with a 25-year amortization, the payment would be $412/month. For rates to rise so that interest is $412/month, the rate would have to rise to 4.95%.

That would be a rate increase of 3.2%. If you are right, TD would increase your payment if rates rose MORE THAN 3.2%.

At BMO, rates would have to rise more than 3.2% plus increase the mortgage principal by 5%. That would mean, for example, an additional 5% for 1 year or 2.5% for 2 years. So, rates would have to rise by 8.2% and stay there for 1 year or 5.7% and stay there for 2 years, etc.

I guess that is why our contacts did not know the answer and said they have never seen a case where the payment was increased.

I can also say that in 15 years of referring people for a mortgage, I can’t think of a single case when a mortgage payment on a variable was increased.

We don’t deal with nearly all mortgage companies, so if having a payment increase is the major issue for you, then you should ask the mortgage person exactly how high rates would have to go before they would require a higher payment. See if your mortgage rep knows how high rates would have to go! :)

I am trying to understand why you continue to talk about how variable offers clients flexibility. Your two main arguments for 1 year or variable are:

1/ Save money on your mortgage – I agree with this point. I am not sure that offering this advise to all client in all financial circumstance is the best thing to do. It is your blanket approach and you have made that clear. I am surprised however that you would offer this to the majority of your clients yet you cannot explain to them the biggest risk associated with a variable mortgage. Will payments increase as prime increase? Will payments increase once the trigger rate is achieved? How does increasing prime affect my amortization? These all seem to me as being basic questions on a VRM. You cannot focus soley on the fact that over history a VRM safes clients money without also disclosing to them that in order to get to that end scenerio there will be some heavy fluctuations in payments. Prime over the last 25 years has ranged between todays lows and 11.50%.

2/ Avoid risk of losing home – Clients who get in to trouble with high interest credits, loans that they wish to pay, education cost for kids or investing…. whatever the expense is. Fixed rate mortgage can be added onto WITHOUT PENALTY. Clients can blend existing terms with a new term on the new portion of funds added to mortgage. You cannot add-on to a VRM without closing and reopening the mortgage. This mean that “deep discount” you may have had on the mortgage you may not be able to get… especially if economic factor play into you cash crunch… It those times spread are usually low as we have seen in the last 18 months and dicounts on VRM are non-existent. And you final point about someone who loses their job, which is the worst case scenerio. Clients in either case would have to requalify for for EITHER a VRM or a FRM. How does a VRM add flexibility to a client that does not qualify.

As I have said in the past…. and I work for one of the banks you use… A client is in no better position to negotiate on a 1 year deal or variable which in most cases in a non-negotiable product. Why…?? the risk to the bank is greater as the mortage could walk out the door tomorrow ( in a case of a variable open or next year (in the case of a one year term.) You like hockey analogies. What are the chances that Kovalchuk will shop himself around for a 1 year contract? Very low, and the reason why is he risks losing the security of a long term contract that gaurantees him income in the event of an injury. Now remember Kovalchuk is the best UFA out their… he has lots of negotiating power as do clients that have equity, RSP, Investment, job stability. Most banks will not give more discount without the client agreeing to bring more business. You have talked about it before. It is not tied selling it is relationship pricing!! What I am getting at is that hockey players like clients are in positions of strengh in negotiation based on what they bring to the table not by the fact that they just play hockey or hold a mortgage…

tster Eds a big boy and does not need me to defend him however he has already stated that his suggestions might not be for everyone. How can you suggest that a short term rate does not improve your flexibility. 120 days before the end of the mortgage i can lock in rates for any term with many institution Technically im only locked in for 245 days in a one year fixed. If i encounter hard times i can bail without an excessive penalty for doing so.If im in a variable and rates look like there getting out of hand i can lock into a fixed.

I have never said that a 1 year term or VRM is not flexible… I did say the following: “How does a VRM add flexibility to a client that does not qualify.” This statement is absolutely correct. A variable rate mortgage to a client that does not qualify is no more flexible than a FRM with the exception that you can get out without penalty. In other conditions you would be a fool to not believe that an open or short term mortgage is more flexible. My point to Ed was that it doesn’t add negotiating power to you position. Your negotiating power is reflective of what you can bring to the table. Ed has made it very clear that 90% of people should be in VRM. So in every comment that has been made not once has he stated that the client should take a FRM of longer than one term. So her HAS said that VRM are for everyone. It was even asked to him if he would give the same advise to a 70 year old as her would to a 25 year old. A question he never answered. As well as what his suggestion would be for investment and telling client to all be in equities instead of bonds since in the long run the will make more money… Another question he never answered.

You are correct in your 120 day early renewal… But you must renew to a fixed rate term with the financial insitution that holds you mortgage. I know you CANNOT early renew to a VRM open… but need to check on a VRM – closed. Once again I am not sure how much negotiating power you have when the bank knows that the mortgage must be renewed with them. And with the majority of client not having any idea of when the mortgage renews and in some cases signing renewal documents without even talking with their FI… that leads me to believe that the vast majoirty would not go out and apply with other FI’s in order to hold their rate until their mortgage could actually be moved.

Don’t get me wrong Ron. I suggest VRM to many clients. But it has to fit their lifestyle taking many things into accout including thoughts of building (not moving since mortgages can be ported), future education cost, debt levels, equity levels, job stability. I believe VRM are the best way to go…. but thats for me personally. I would not make statements that suggest that all clients should be Variable and not have the stability of a fixed rate in a rising interest rate envirment.

Just to be clear – you are agreeing with me that a short term or open variable mortgage is more flexible – for those that qualify for a mortgage – right?

Then you must agree that someone with a mortgage due is in a better negotiating position than someone trapped in the middle of a term – right?

Two things that we think people should never do is “port” a mortgage or “blend and extend”. Both these end up adding an additional amount at the posted rate. You can’t really negotiate that. Posted rates are for losers!

I understand you point about the mortgage needing to fit the person. But do you agree that the vast majority of people are better off avoiding the 5-Year Fixed Mortgage Trap, Tster?

It’s hard to put a number on it, but I would estimate about 90%.

In short, we think that 5-year fixed is the “Poor Man’s Mortgage”. It is for the desperate, poor and fearful that have not set up any emergency funds, don’t qualify for a credit line for emergency use, are “2 pay cheques from bankruptcy” and are willing to pay thousands more in order to avoid an unlikely chance of a larger increase. They are for pessimistic people.

Variable and 1-year mortgages are for financially stable people. They are for people that want to build wealth or save money, that are not on the verge of bankruptcy and that have some savings or available credit for emergencies. They are for optimistic people.

Some people are taking the 5-year fixed now because they think “this is the one time when it might save money”. That is possibly true, if you are willing to lock yourself up for 5 years without being compensated for it.

Remember, the 5-year fixed is the “Foreclosure Mortgage” largely because of a huge penalty that prevents people that can’t afford their mortgage from selling their home for enough to cover the mortgage & penalty. If they could sell and get out, nobody would let their home be foreclosed on. That is possibly the best example of why being trapped is risky.

Part of why we don’t recommend 5-year fixed is that our clients tend to be focused on saving for their future and building wealth. They are following a written plan to achieve their goals, so taking a “Poor Man’s Mortgage” would rarely make any sense for them.

Ed 5-year fixed is the “Poor Man’s Mortgage”. It is for the desperate, poor and fearful that have not set up any emergency funds, don’t qualify for a credit line for emergency use, are “2 pay cheques from bankruptcy” This was almost me when i bought my home. i still went with a one year term for the first 2 years, then 5 year fixed 4.35% and have been in variable for the last 2 years. I think the guy 2 pay checks away from bankruptcy is better of in a one year (lower penalties to terminate the mortgage) Also a year and a half into my 5 year prime went passed 4,35% but i think i still lost in the end. paying down a variable at the same monthly payment as the 5 year fixed would probably have been cheaper. A lot of people dont want to gamble with their homes and for good reason. unlike las vegas though the statistics are in your favour when you avoid 5 year fixed

Hi Ed, I dusted off an old wealth management book the other day…written by Charles Givens (Wealth without Risk, Cdn Edition). You sound a lot like him, sticking with mutual funds, and using leverage to grow your wealth. The one area where you differ is in the 5 year fixed vs. VRM, as he recommends that you go long with your fixed mortgage. Of course, that was written in 1992 after years of double digit prime rate. And being “translated” from American to Canadian, there could have been something lost in the translation, as Americans typically have longer terms anyways. He did have an interesting point on starting out with a 15 year ammortization schedule, in that it only increased your payments by 16% over a traditional 25 year.

Personally, I’m an advocate of what you are saying with regards to mortgages, as I am in a discounted VRM and plan to renew that way next year, unless the 1 yr fixed is a better deal.

I’m interested to hear your thoughts on Givens’ approach…even for an old book, some of his strategies still made sense.

Part of why we don’t recommend 5-year fixed is that our clients tend to be focused on saving for their future and building wealth. They are following a written plan to achieve their goals, so taking a “Poor Man’s Mortgage” would rarely make any sense for them.

And herein lies the problem, Ed. As I’ve noted above, your posts consistently make sweeping generalizations under the assumption that everyone is like your clients.

Alas, as much as we would like it to be so, the reality is that relatively few people are actually like your clients. Most people do not have the disposable income or risk tolerance to use leveraged investing like the Smith Maneuver. Many people cannot take the risk of payments increasing. We can smugly say “well, then they shouldn’t be buying a house”, but that isn’t going to change the reality that they are buying houses. And if they are so intent on buying a house despite their limited resources, blanket advice geared towards people with significant resources is not likely to serve them well.

Nobody has disagreed with you that VRM is likely to save money. But, you need to recognize that VRM is not a good fit for many of the people who do not resemble your clients. Like Tster, I find it extremely disconcerting that you do not seem to understand the concepts of “trigger points” for VRM, that you literally say “who cares” to the potential for clients to spend 5-years making payments only to owe more on their mortgage than when they started, and that you do not acknowledge that there is considerable risk to having negative equity in your single largest asset class.

Thanks Ed & all – This thread and all the banter has been extremely useful in my deliberations. I have nearly closed my refinance and the rates dropped yet again and so I have managed prime -.8 (at 3 or 5). Indeed, it has paid to wait a little, wise up, and to shop brokers not banks. While there may be deeper discounts pending, I feel okay at this time. It is much better than my original 6% (back when I was desperate, poor & fearful). :D

In general, the same concepts for saving money apply to both residential and investment mortgages. Commercial mortgages are a completely different animal and usually much more expensive, but residential investment mortgages are similar to personal mortgages.

We often hear people being less concerned about the interest cost of a rental mortgage because it is tax deductible, but saving money is saving money. In addition, it is generally smart to pay off a rental mortgage as slowly as possible and focus on paying off the non-deductible mortgage on your home. Rental income is also highly taxed once the mortgage is paid down a lot.

So, having lower interest rates by sticking with variable and 1-year mortgages might be more important with rental properties, since you may maintain that mortgage much longer.

Hi Ed, I’ve always beleived in short term being better than long term. But with the 5 year fixed at an all time low @ 3.59, compared to variable open @ 3.50, variable closed @ 2.25 and 1 year fixed @ 2.45, i’m starting to change my mind. What do you think? Thanks.

If you want to pay more and sleep at night go five years fixed. If you want to save… avoid the mortgage broker…bank talk. Remember brokers don’t get paid as much unless you sign for five years vs. one year or less (like open mortgage)

I agree that it the savings from going short are less obvious when rates are expected to rise, but we believe that going short is virtually always the best thing to do.

The reasons we would stay short are:

1. The 5-year rate is hardly lower than an average mortgage rate in an average market. So capitalize on low rates for a year or 2.
2. Most likely, the average of the next five years’ 1-year mortgages will be lower than today’s 5-year rate (because it is based on the bond market).
3. 5-year fixed is the risky mortgage, not the safe one. Fear of a huge rate rise is vastly over-blown, but we have seen so many people pay the penalty to get out of their 5-year fixed.
4. The flexibility to refinance whenever you want that you have by staying short can be quite variable. We would want a significant clear savings before we would ever consider locking in anything.

Today we still have very low interest rates. This is a great time to capitalize on them!

Today’s 5-year rate at about 3.59% is not really much of a low rate. We have been recommending either variable or 1-year and rates have been between 4-4.5% most of the last decade.

So, 3.59% is only about .5% lower than an average rate in an average market.

Why not take this opportunity and have a really low mortgage rate? Rates will likely normalize over the next year or 2, but meanwhile, you have saved money for a couple of years.

Will you save money over the 5 years? You can do some simple math and estimate how much rates would have to rise to be even. If you take 3.59% * 5 years = 17.95%. If you get 2.45% for the first year, then take 17.95%-2.45%= 15.5%, to be even the average of years 2-5 would have to rise to 15.5% / 4 = 3.88%.

So, rates would have to rise by a bit more than 1.4% and stay there for years 2-5 to be even. Will they? That is hard to say, but most likely not.

Mortgage rates are based on bond market rates, which are based on the expectations of millions of investors. Bond market investors will always want a premium to take a longer term mortgage. Therefore, 5-year rates will ALWAYS be higher than the expectations of all investors for the average 1-year mortgage during those times.

Bond markets are far larger than stock markets and bond investors are generally better at forecasting than stock market investors. This is why short term rates have so consistently beaten longer term rates. The one study I saw from a mortgage broker showed that five 1-year fixed mortgages saved money over a 5-year fixed 100% of the time since 1950!

Many people feel “safer” in a 5-year fixed because of a fear of very high rates, like we had in the early 1980s. Things are completely different now. The main reason for the high rates in the 1980s is pushing rates down today.

The main reason for the high rates in the 1980s was demographics – millions of Baby Boomers entering the housing market every year and creating huge demand for mortgages. At the same time, there was a very small population of older Canadians that usually buy GICs, so the banks had little money to lend and tons of demand. Rates had to rise to even things out.

Baby Boomers are still the main driving force in the economy, but they are in their 50s today, so they are more likely to exit the housing market than enter it in the next decade or 2.

So, we think a large rate rise like that is very unlikely.

We see 5-year fixed mortgages as risky – not “safe”. The big risk in mortgages is that something will change in your life and you may want to refinance or (heaven forbid) have trouble making your mortgage payment.

With a 5-year fixed, there is a risk of having to pay a large penalty, which is part of why people with long term mortgages are far more likely to lose their home in a foreclosure.

The biggest factor, though, is that there is a big benefit in keeping flexibility being able to refinance. You may incur some debts that you could refinance into your mortgage, want to buy a car, move, etc. With a 1-year mortgage, you can refinance for free every year.

We would want a clear significant savings before we would recommend locking in a mortgage and giving up the flexibility to refinance.

For those that locked in to a 5-year fixed at 3.59% 6 months ago, it is looking like it will end up costing you more. Current projections are that interest rates will stay at this level for a minimum of 1 year and probably 2.

That means that by locking in, you will have paid about 1% more than a 1-year fixed and about 1.5% more than a variable mortgage for all of the first 2 1/2 years of your term.

Good question. Today’s mortgage rates are really strange. We are actually getting a 2-year rate that is lower than both 1-year and variable.

Normally, we just take whatever rate is the lowest, regardless of the term. In most markets, you pay more for longer terms, but the amount you pay is usually expensive given the odds that interest rates will rise enough to save you money.

The best rates we are seeing today are:

Variable: prime -.2% (2.8%)
1-year: 2.69%
2-year: 2.49%
4-year: 2.99%

We are going with the 2-year in most cases.

The 4-year fixed is intriguing, but the 2-year will save you .5% for 2 years. You will be ahead unless the average of years 3 and 4 are more than 3.49%.

Like normal, it looks expensive to pay the extra .5% with the 4-year, plus you lose your negotiating power for 4 years, instead of 2.

It is difficult to know where interest rates are going now. It looks like they will stay low for a couple of years, and they may stay this low longer. Most likely, the economy will eventually come back and interest rates will normalize at perhaps 1% higher than today’s rates. That could happen soon or it could take 4-6 years.

There is also a possibility that when rates rise, they go too high first before settling down, as well as other possibilities. It is hard to predict rates long term and probably unproductive.

Generally, you should just go with the lowest rate, which today (for the first time in memory) is the 2-year fixed.

We are getting it from our contacts at BMO and I believe also TD. If they don’t give you that rate, we can refer you to our contact. Just fill in the “Ed’s Mortgage Referral Service” page on our web site. The link is on the right side above the graphs.

The 5-year fixed has never worked and is unlikely to work now, as well. I think the best option today is the 2-year fixed at 2.59%.

The 5-year fixed of 2.99% being offered today has very restrictive terms. If you take the 2-year, you save .4% for the first 2 years. It would have to average higher than 3.26% in the last 3 years for the 5-year to save money, which is a rise of .67%. It’s very hard to predict interest rates, but I think a rate increase that large is unlikely. At this point, the Bank of Canada is still talking about rates staying low at least 2 years.

The variable rate is tempting and lower than the 2-year fixed now, but we’ve been holding out for the larger discounts from prime. For years, we were getting prime -.85% or even better. I think those discounts are still likely to return once rates rise a bit, so I would hesitate to lock into a 5-year variable.

Even if I thought rates may rise enough so that the 5-year fixed might save a bit of money, staying shorter keeps you flexible and able to refinance. I’ve seen way too many people pay large penalties to get out of 5-year mortgages, fixed and variable, to think of them as the “safe” option.

Ed, thanks for the reply! Embarrassingly, I completely forgot about this post until now. But my own research came to the same conclusion of the 2-year fixed at 2.59% so, I’m glad I’m on the same page as you. I also want to do smith manouevre once I move to more permanent home in a few years, so only locking in for 2 years is ideal. When I’m ready to do the smith manouevre, I’ll be contact your experts :) Other criteria I have for now is lump sum payments and being able to port mortgage penalty-free (if i decide to move). Met with a mortgage broker today who agreed (although she did try to convince me to go 5 year at first). She suggested First National or Street Capital, and was going to do some more reading and set up another meeting.
Interestingly, she discouraged me from getting a HELOC added as an emergency fund, since she said it can be hard to port those if I were to move (since they are set up separate from the mortgage) .

This is a great article! And from my experience, very accurate. Over the years, I’ve had a combination of mortgages: variable, fixed, and line of credit. The worst by far? You guessed it: The 5-year fixed. And for the exact reasons mentioned here:

1) When I sold a property, and broke a five-year fixed, I paid about $3000 in mortgage cancellation penalties. And it could have been worse, because the mortgage was modest in size, ie under $100 000.

2) Interest rates have essentially gone down over the last 10 years, so fixing for 5, has been a raw deal. No wonder this has always been the case since 1950. Some of these mortgages have been for rental properties, and since the interest can be written off as an expense, I’m keenly aware of the added cost for a five-year fixed!

Now, I use a Home equity line of credit (HELOC). Interest rate is higher at 3.5% (prime +0.5%), but there is no restriction on prepayment. Any immediate income I receive is used to pay down the principal. You pay the mortgage down much faster this way. Plus any larger purchases for business use (eg renovations to rental properties) are put on the HELOC, to write off a portion of the interest. Just be sure to keep the appropriate documentation.

I also have used short term mortgages. The interest rate is usually similar or better than the 5-year fixed, without all the worries of cancellation penalties. Check to see how much it will cost to cancel a 1-year mortgage early. Likely it won’t be much, because you’ll always be close to the renewal date.

My last 5-year fixed will expire this December. What will I do? Because I may sell the property with the next few years, HELOC and/or 1-year mortgage!

Alpha,
Get your bank to match RBC’s HELOC rate at prime. The +0.5% is pure gravy that I had my bank reduce on all my HELOCs, otherwise I would have taken all my accounts elsewhere. I went to two other banks who offered prime and were willing to pay all transfer/appraisal costs.

I use only HELOCs to finance properties and my bank now gives me the max. HELOC on new purchases instead of a mortgage. As you said, pay down is faster, easier and the paperwork is so much simpler than a mortgage since it just involves placing a lien. Purchases are now quick and streamlined.

One other item worth mentioning is the bargaining power of a HELOC. Even in today’s competitive (sometimes insane) real estate market, a no financing offer with a closing date of whenever the owner wants, still affords me the ability to buy at a lower, more reasonable price. Though it’s much tougher out there than it’s ever been to pull this off, especially when it comes to premium properties that will have multiple rental offers.

Great article. Perhaps I missed it, but how do discharge fees (when switching mortgage lenders at end of term) figure into the equation? Here in Ontario, the norm seems to be in the $200-$400 range. If I’m charged that kind of fee at the end of each term, then the benefit of a shorter term could be cancelled out by these fees.

I’m looking for a mortgage as soon as possible. I’m having only 5% down payment. And 90% i’ll be staying in this house for more than 5 years. So in today’s market rate is it better to go for a 5 years fixed or short term fixed or variable. I’m eagerly waiting for your answers. I need to take mortgage default insurance too…

@Mathew, going variable has historically been a money saver vs fixed. However, I believe home owners should go with the option that makes the most sense. The fixed mortgage will provide financial stability in knowing your payment every month for x number of years. Have you considered another approach where you go fixed, but for a shorter term? right now, I see the 2 and 3 year fixed mortgages are very attractive.

Thanks Fruga .. Really appreciated your help !!
1) Now the interest rates have gone up a bit from November 3rd 2015. Approximately 0.50% increase. I’m scared in 2-3 years it might still go up. In your opinion, is it better to get a mortgage from Canad’s leading bank for 2.90% for 5 years fixed with no clause or for 2.44% with private lenders with a clause stating that for 5 years i cannot payback my mortgage fully nor withdraw the mortgage unless i sell the property by paying penality?

2) Is it good to wait till Feb 2016 for a 0.50% decrease or its better to get it today’s rate and move out ASAP ….

Remember that if you speak with a mortgage broker, they will lock in the rate for 90 days. Personally, I’m willing to take some risk, so I would go for 2 or 3 year term then renew. Can you provide more details as to what private lenders are offering?

I think the best choice today is the 2-year fixed. It is the lowest of the shorter-term fixed mortgages. We’re getting between 2.19-2.29% recently, depending on the day and the borrower.

This is up only .1% from a few weeks ago. 2 years ago, we were getting 2.79% and everyone was saying “rates can go nowhere but up”.

The 5-year fixed has never worked, as the article explains. When a mortgage person recommends a 5-year fixed, I usually take it as a sign they do not have your best interest at heart.

5-year variable rates are similar to the 2-year fixed, but require a 5-year lock-in. It’s useful to have your mortgage come due more often, in case you want to refinance in some way or take advantage of your negotiating power with the bank.

Whether you go with a bank or broker, get the lowest rate, negotiate having your appraisal fees paid, and avoid any of those restrictive clauses you were quoted. (You can usually also get your legal fees covered, but not when you purchase a home.) Usually, banks are more likely to absorb these fees.

I’m in a bit of a bind in terms of my mortgage as well… was hoping to lean on your expertise for advise.

My current mortgage is coming due in the next 3 months and I’m looking for a renewal. The catch is that I’ve purchased a pre-construction home that will be completing in Q4 of this year, which means that I will need to sell this current home and obtain a larger mortgage within 6-8 months of renewing.

Some relevant facts for my situation:
– The new home is roughly double the cost of my current home… I will be doubling my mortgage
– I would like to start the Smith Maneuver on my new home’s mortgage

So far the options I’ve been given by Mortgage brokers and banks are as follows:

1. Lock into a fixed or variable rate 4-5 year now and when the time comes for the new house, they’ll port the mortgage and give me the market rates at the time creating a blended rate. — I have serious reservations about this as they would essentially have me hostage to whatever rates they want to offer.

2. Take a variable mortgage and if i want to break it incurring 3 months interest.

I’ve been offered very good rates for 1 year (1.99%) and 2 year fixed (2.19%), and a decent 5 year variable (2.15%). 5 Year fixed is around 2.7%.

I’m leaning towards taking a variable 5 year mortgage and seeing what happens in Q4 when its time for a new home. I was wondering:

1. If I take a 5 year variable for 50% of my mortgage… is it likely the bank will allow me to take a 2 year fixed for the other 50%?
2. Since I’ll start to become heavily leveraged using the Smith Maneuver… will it be hard to qualify for the best mortgage rates every 2 years using the short term strategy?
3. Do you think taking a 5 year variable rate for the current mortgage renewal is smart given my situation?

I’ve been out of the mortgage game for quite some time. But from what I can see, what about the option of taking an “open” mortgage, then locking in the new mortgage when you finish the new house? Are you in a rush to setup the SM now because you want to invest the proceeds into the stock market ASAP?

Ive asked a bunch of providers to give me an open rate and they all immediately dismiss it. Im beginning to think they are incentivized against it. I will continue to pursue one as an option though. It seems to work for me as long as the new construction isnt delayed more than 6-8 months… Which its too early to tell now if it will be.

Im not in any rush to start SM, ideally id like to start q4 this year or q1 2017. Im thinking long term (25-30 year horizon) so I’m not too fussed about a 6 month delay.

Ive seen open rares of 3.2%.. Do you think its worth it to take that vs a 2.15% variable and keep my options “open” in September /October when the new house is done?

Nik, best bet would be to run the numbers on the extra interest the open mortgage would cost vs. the penalty of the variable rate mortgage. You might want to get solid penalty numbers from your mortgage broker to avoid any surprises.

I ran the numbers, and it seems that even with Break fee penalties, it makes sense to go with the Variable rate since the incremental amount we’d pay into the house plus the money saved under the lower variable rate would end up being more than the break fee.

Quick question for the experts. Looking into getting first mortgage and have been quoted 2.14% (prime-.55) for a 3 year var and 2.05% (prime-.65) for 5 year variable. I know the article states that long term fixed rates (5 year fixed) are a bad idea but in this scenario it looks like the 5 year var is the better option. I just don’t see how the 3 year would be a better option especially if we are looking to live in the house for over 10 years.

I think the premise of this article isnt’ 3-year vs. 5-year variable, as in that case the cost to get out of either of these mortgages is the same and there’s no indication that you would get a lower variable rate in 3 years vs 5 years.

The point is more around 1, 2 and 3 year fixed vs 4 or 5 year fixed or 3 and 5 year variable options.

If you take a look at some of the mortgage rate sites online, you’ll notice that 1, 2 and sometimes 3 year fixed offerings are coming in at lower than 3 and 5 year variable offerings. I’ve seen 1.99% on a 2 year fixed. To me, under the right situation (i.e. not moving soon, don’t need any special products like HELOC or cash back, etc…) this makes more sense than locking into a 5 year fixed rate that’s almost 0.7% more or a 3/5 year variable rate that could fluctuate over the term.

Even if the rates are up when you come out of the 2 years, the 2 year rates at that time will probably still be better than the 4/5 year fixed rates and still comparable to the variable rates. Also if you consider the time value of money (i.e. money saved today is worth much more than money saved 3 years from now), locking in such a low rate in years 1 and 2 allows you to accept higher rates in years 3 – 5 and still come out ahead.

People could disagree, and I’m sure its different for everyone, but it seems like shorter fixed terms (which are discounted) seem to save people more money.